Dodging the Dollar's Decline

The greenback's fall against the euro has helped push European bourses lower. S&P strategist Clive McDonnell looks at some smart plays

One of the factors roiling European markets of late is the U.S. dollar's weakness against the euro. With such a wide gap -- the euro traded around $1.28 on May 31, vs. $1.18 on Jan. 1 -- it spells trouble for many European outfits who depend on the U.S. market for a large proportion of revenue. It's a major factor contributing to volatility in global markets.

How long will the dollar's weakness against the European currency last? Where should investors in Europe be looking now? Clive McDonnell, S&P's chief European equity strategist, spoke with BusinessWeek Online reporter Alex Halperin about why the dollar is unlikely to climb soon and where investors should look for bargains. He also explains why there are "good" and "bad" budget deficits. Edited excerpts from their conversation follow.

What do you see behind the euro's rally?

It's very much a weak-dollar story as opposed to a strong-euro [one] in my mind. But I think there are two primary factors that have been influencing the euro-dollar exchange rate. One is the difference in terms of benchmark bond yields, the difference between 10-year bond yields in the U.S. and 10-year bond yields in Europe.

They had been, up until maybe two months ago, pretty supportive of the dollar, I think the [yield] spread was around 110, 115 basis points [higher for U.S. debt], and that was way up from where we were 12 or 18 months ago.

Over the past two months it has stopped climbing and sort of stabilized at about 100 basis points, which is still quite a respectable yield pickup. But despite that you've seen quite a change in sentiment toward the dollar. Whereas the spread is a cyclical factor, the structural factor has started to kick in. [That factor] is the [U.S.] current-account deficit.

People are always focusing on that as a bearish sign. The size of it, whether it's too big or too small, is a very arbitrary estimate to put on an account deficit. What is important is the funding of it.

The bottom line is that it has been fairly well funded up [by foreign purchases of U.S. debt] until the fourth quarter of last year when it was not well funded, and some of the leading indicators aren't great for the first quarter either.

So you're saying this could be for the long haul?

Our S&P economics team's view is that the outlook for the dollar is bearish, and we're talking about an exchange rate against the euro going over to $1.43 into the end of 2007. The economics team has been bearish on the dollar for a while.

In a recent S&P report you mention good and bad deficits. Can you explain that a bit?You could think of the contrast between Germany and America. In Germany they have a surplus at the moment, but one of the reasons why they have a current-account surplus is that consumers effectively aren't spending. They're not attracting so many imports.

In the U.S. you have a situation where consumers are consuming too much. Imports are way, way up, and that's creating a huge deficit. You combine interest rate and profit flows, and that's giving you a current-account deficit. On the one hand, people are quite happy that American consumers are spending so much but one of the negative implications of that is a negative account deficit. Whereas in Germany people are disappointed that consumers aren't spending so much and one of the implications of that is a current-account surplus, a trade surplus anyway.

The issue of good or bad deficit comes down to: "To what extent is the deficit funded?" Up until [the fourth quarter of last year] the current-account deficit in the U.S. has been more than sufficiently funded. And if it's funded properly investors should not be overly concerned about it. In the fourth quarter we did get this basic balance deficit, and that starts to set off some alarm bells.

To what extent do you see the dollar's weakening as responsible for recent falls in European indexes?

There's no single factor that you can put your finger on and say, "This is the factor that's responsible." Rather, there's been a convergence of events including a pickup in inflation, concerns in the market -- and the appreciation of the euro against the dollar has been a factor as well, as have concerns about the outlook for German growth in 2007. Those three factors are certainly behind the correction.

So it was a correction rather than something that's going to continue?

We believe it is a correction and we do not believe it marks the beginning of a new bear market. We recently highlighted that it's going to be a tough summer [for European equities] and further challenges lie ahead in 2007. But at nearly 11.5 times earnings the market is now arguably cheap. Earnings growth has actually been nudged upwards a little bit thanks to good first-quarter numbers. So the fundamentals are fairly positive.

I don't expect those positives to be reflected in market performance overnight; it'll be a tough summer as we get used to higher European Central Bank rates. But if those fundamentals remain positive later in the year, I think the market should recover some of its poise.

You discuss that there are still some strong stocks, even in sectors heavily exposed to currency fluctuations. What are some of the factors that can help a consumer stock at this point?What we're basically looking at are the proportion of earnings that are generated overseas. Investors concerned about a weak dollar want to be invested in sectors that have a relatively low proportion of earnings generated overseas or have explicit natural hedges in place. By natural hedges, I mean by matching local revenues with local costs.

Are there any surprise stocks for which the outlook is more positive than one might think?

We've done this research before, [on] analyzing profits generated overseas in terms of natural and financial hedges, and the results are pretty much in line with expectations. [The exception is] the health-care sector. The sector is one of the most exposed to overseas earnings.

Our analyst has highlighted [companies where] management has tried to match foreign revenues with foreign costs, whether it's research and development or manufacturing. The examples are GlaxoSmithKline (GSK) [in Britain] and Novo Nordisk (NVO) in Denmark.

With the bearish outlook on the dollar and increased currency volatility in the exchange rate, where do you see the smart money going in equities?

The smart money is basically going to embrace the utilities sector and several companies in the consumer space. We've highlighted companies such as Nestle, Unilever (UN), Pernod-Ricard, and Continental, the German tire manufacturer, as potential winners during a prolonged bear market for the dollar.

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