Faltering US dollar poses dilemma for equity investors

Investors in US stocks have viewed the recent decline in the dollar as a green light to buy into large companies with international exposure.

MasterCard, for example, is a company with large overseas operations that has boosted its recent earnings amid a weaker dollar. Its first-quarter profit soared 70 per cent compared with a year ago, partly because of the stronger euro against the dollar. Its shares jumped 11.2 per cent to $127.67 on Wednesday after the announcement.

But analysts warn that a faltering currency looms as a double-edged sword for equity investors.

"At some point, foreign investors will either hedge their US assets or repatriate," says Dominic Konstam, head of interest rate strategy at Credit Suisse.

So far, the dollar is seen to have made an orderly decline to compensate for a divergence between US and global growth rates.

In the wake of last week's news that the US economy grew just 1.3 per cent during the first quarter, the dollar fell to a record low against the euro and multi-year lows against sterling and the Canadian, Australian and New Zealand dollars.

This, analysts say, has encouraged local and some foreign investors to buy US stocks – which now look relatively cheap in their domestic currencies.

"The lower dollar has helped equities as the currency has adjusted for the slower economy and lower US investment returns," said Mr Konstam. "If the dollar doesn't fall, stock prices would come under pressure."

While the dollar has fallen by about 2.75 per cent against the euro for the year to date, the Dow Jones Industrial Average is up 6.1 per cent and the S&P 500 is up 5.9 per cent.

But if the dollar continues to weaken substantially, there will soon come a tipping point when foreign investors will no longer be satisfied with the returns from US assets.

Jack Ablin, chief investment officer at Harris Private Bank, said he was "a little worried about a replay of 1987 where the stock market kept going higher while the dollar quietly fell, adding: "Eventually, investors stood up and noticed."

The prospect of higher inflation beckons from a lower dollar, an outcome that, if accompanied by a slowly growing economy, represents the worst environment for stocks later this year, analysts say.

Investors are likely to watch the April jobs report, due on Friday, for any evidence that the labour market is weakening.

For some foreign investors who purchased US stocks at the start of this year, the recent market gains are not as impressive when viewed in their own currencies. In terms of the euro, the Dow's gain for the year is 3.2 per cent while the S&P has returned 2.9 per cent.

The one factor keeping back the risk of a massive net selling of US stocks by foreigners is the weak yen, according to Mr Konstam.

"So long as the dollar is stable against the yen, the threat of such an outcome will stay contained. Dollar-Asia is a very important gauge of repatriation risk," he says.

Copyright 2007 Financial Times