The Drawbacks of This Brawny Greenback
By Amey Stone
After two strong days for stocks, you might expect a cheery column about how the worst is over and the market appears to be rebounding. Sorry folks, but there are still plenty of worries on the investing front. Stocks are indeed starting to look cheap based on current earnings. But the profit picture could still worsen from here. How? Have you looked at the dollar lately? Increasingly, economists and investment strategists are focusing on potential currency problems.
In spite of lower interest rates and a slowing economy in the U.S., the dollar is showing surprising strength against the world's major currencies, creating its own form of economic anxiety. Normally, when the Federal Reserve is lowering interest rates, the dollar weakens as investors seek higher yields elsewhere around the globe. A weaker dollar gives U.S. companies an edge: They have the possibility of raising prices to increase revenue at home, and their competitiveness in global markets is enhanced. Some economists believe a weaker dollar is practically a prerequisite to reversing the economic slump but say it's still nowhere in sight. Analysts don't see a weakening dollar in the near term because economic distress in Japan and uncertainty in Europe are persuading investors to stay away from the yen and the euro.
The greenback's stubborn strength greatly dismays U.S. monetary policymakers. It has risen 6.4% against the euro since Jan. 1, and 7.2% against the yen during the same period. The basic explanation for persistent dollar strength is that, as weak as the U.S. economy may seem, global investors consider it the safest place to be. Robert Smith, president of Smith Affiliated Capital, points out that investors have great faith in the Federal Reserve's ability to maintain stability in world financial markets. But with President George W. Bush's campaign declaration that, as President, he would eschew interventions in a currency crisis abroad, investors are motivated to keep a good chunk of their money in dollar-denominated investments.
That isn't necessarily the best state of affairs for a healthy global economic outlook. "Generally, when the economy weakens, so does the dollar, and that can offset the problems a domestic slowdown creates for corporate earnings," says Richard Moroney, editor of Dow Theory Forecasts newsletter. That's because when the dollar weakens, profits earned overseas get a boost as they're translated back to U.S. dollars.
"Now it is kind of going the other way, which is contrary to a lot of expectations -- including mine," Moroney says. It also means more trouble on the U.S. corporate-earnings front for some large multinationals, drug companies, and Old Economy outfits that had been hoping to export their way out of weakness in the U.S.
The yen is the biggest cause for concern as Japan slips back toward recession and a financial crisis that some fear could make the U.S. slowdown look like a walk in the park. (See BW Online, 3/26/01, "Japan's Leading Role in a Potential Nightmare"). Japan's government has been trying to spend its way out of trouble, resulting in massive public-sector debt and banks buried in bad loans. While a weak currency helps Japan's exporters, it exerts upward pressure on other Asian currencies, as their exports become more expensive compared with the yen. It also hurts U.S. companies whose goods become more expensive and thus, less competitive, exports.
You can imagine that no one is interested in revisiting the kind of market meltdown that accompanied the Asian financial crisis of 1997-98. "Japan's renewed weakness is bad news for the global economy, bad for Southeast Asia, and bad news for us," says Lara Rhame, currency economist at Brown Brothers Harriman. There are fears that Japan will continue to let its currency weaken, but many experts are hoping that the government will begin renewing its restructuring efforts when the nation's new fiscal year begins on Mar. 31. Without some movement in Japan, the world's two largest economies would be in trouble at the same time, presenting a dilemma for investors in search of an economy on the upswing.
While Europe is in much better economic shape than Japan -- indeed, it is forecast to grow at 2% this year, vs. 1% for the U.S. economy -- the bad news there is that tepid growth won't be enough to lift the rest of the world out of a slump. On Mar. 23, European Central Bank (ECB) policymakers admitted that growth is slowing in the eurozone, and they are widely expected to cut interest rates to stimulate economic growth -- perhaps as early as Mar. 29, when the ECB next meets. But ECB policymakers are walking a fine line as they work to stimulate their economies without worsening inflation, which persists at 5% or more in many eurozone countries.
Even if the ECB cuts rates, its bonds are paying higher returns than what is available in the U.S. or Japan. That should help the euro strengthen against the dollar in the coming year. "We believe the undervaluation of the euro compared to the U.S. dollar is quite strange," says Arnaud de Bresson, managing director of Paris Europlace, a financial trade group for the eurozone based in Paris. He is convinced that foreign investment in the euro will continue to rise as the Fed goes on cutting rates in the U.S.
Smith still thinks the ECB will have more convincing to do before investors start buying euros. The region must contend with fears of mad-cow and foot-and-mouth disease, which will hurt agriculture and tourism. "I think dollar strength will continue," says Smith. "There is no other place to hide," he says.
To be sure, a strong dollar isn't the worst thing that could happen to U.S. investors. In the face of a retrenching stock market and a slowing economy, it has been a reassuring sign. Investors have not had to fear that billions of dollars parked in U.S. stocks and bonds by foreigners were about to be pulled out of the U.S., sparking a potentially cataclysmic sell-off in the markets.
The concern now is whether a strong dollar will hamper U.S. recovery efforts. And for investors, the concern has become a backdrop to the central question: When will corporate-earnings growth kick back in? With Asian economies hamstrung by what's going on in Japan, and Europe's outlook far from certain, U.S. companies can't look forward to a surge in demand for their goods overseas.
In that sense, the underlying concern is global economic weakness, not currencies. "If the economies are not doing well abroad, it doesn't matter what the value of the dollar is," says Rhame. But investors should keep their eye on the dollar nonetheless. No one wants to see a complete reversal of fortune for the greenback (since U.S. markets depend on foreign capital flows to stay aloft), but it would be nice if the dollar weakened just enough to help lift currencies abroad. That could give U.S. corporations hope that a recovery might be just around the corner.
Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column.
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Edited by Beth Belton