Monday Morning: Weak dollar isn’t bad news for everyone

Whither the dollar? Or perhaps that should be: “Wither the dollar?”

The dollar has been slipping versus other major currencies, especially the euro and the yen, for the past three months. It could continue to fall.

“So what?” you and your clients might say. Why should you care, especially if you don’t have plans to travel abroad? You should care because the fate of the dollar can have a significant impact on the direction of the U.S. stock market, and possibly even the bond market, in the next year or two.

The impact isn’t clear-cut. Many crosscurrents ultimately will determine the effect on the markets.

causing pain

First of all, the prospect of a declining dollar already may be hurting the stock market by causing foreign investors to pull back. No doubt some pulled back when the bear market began. Others probably pulled out after Sept. 11.

But the prospect of the investment returns from any U.S. market recovery being reduced by a declining U.S. dollar has no doubt convinced more people to pull out their money and put it elsewhere, especially as the European economies appear to be accelerating.

European stock markets may do as well as, or better than, the U.S. market, and without the currency risk.

The data aren’t available yet, but three months from now we will probably find that foreign investors have been selling their U.S. equities, contributing to the current weakness in stock prices. And some large U.S. institutional investors reportedly also are increasing their foreign equity exposures relative to their domestic equity exposures.

Likewise, the prospect of a declining dollar may reduce the foreign appetite for U.S. Treasuries, and that could bring about higher interest rates. So far, domestic demand for Treasuries, possibly from discouraged stock market investors, appears to have been strong enough to offset the impact of any slackening in foreign demand.

But ultimately, fleeing foreign investors could raise interest rates, and rates may be pushed up further by deliberate Federal Reserve efforts either to stabilize the dollar or fight off any hint of inflation. Inflation often is a side effect of a weakening currency as the costs of imports – both raw materials and finished goods – increase.

On the other hand, a weaker dollar would help significant parts of the U.S. economy. U.S. multinationals and exporters, who have had to compete on the world markets with a strong dollar hurting their competitiveness, would find it easier to compete. They would be able to reduce their prices in foreign markets and possibly sell more.

And converting stronger foreign currencies back into a weaker dollar would improve reported profits.

a better deal

Domestic manufacturers, such as U.S. automakers, who have had to compete in the domestic market against foreign manufacturers who import finished products or parts, or both, would find that a weaker dollar would force the importers to raise their prices. That would improve the competitiveness, sales and profits of the U.S. companies.

Improved earnings would lead to better stock prices for those companies. But that perhaps wouldn’t be enough to lift the broad market.

Where does that leave the investor? It means some trimming of U.S. equity positions and no new commitments to bonds until the interest rate increases occur.

The safest place probably is largely on the sidelines until the picture is clearer, until we can see how far and how fast the dollar is going to decline, and whether that will spark significant short-term inflation and therefore higher interest rates.

A modest decline in the dollar, heretofore overvalued by most measures, probably would be painful for the stock and bond markets for the short term but positive for the economy in the long run. A retreat that became a rout wouldn’t be good for anyone.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.