Readers of this blog know our view is that firms reaching out to analysts need to have some situational awareness, and be able to show they understand the wider business environment. Increasingly, this means understanding the impact of the declining dollar and the need to shift to ‘Recession strategies’.
Best estimates are the the dollar will fall 8.5 percent against the Yen by the end of this year: a fall of more than 2 percent per month. The US central bank faces a difficult choice: normally a currency trading out of its normal range, especially one declining in value, would justify higher interest rates to reflect a premium that investors and lenders would need on less predictable assets. However, widespread reliance of consumers, and especially houseowners, on debt in the US means that increasing interest rates could introduce asymmetrical shocks into the domestic economy. We don’t see that happening easily in the run-up to the Presidential elections. Indeed, it’s seemed for the last half-year that the Federal Reserve bank seems more interested in reducing interest rates than increasing them. Reducing the cost of money would encourage investment in US equities: over the next couple of months we expect the main US stock markets may therefore rise even as the US currency falls. However, inside the US this builds up a long term credit risk, and externally it’s just a kind of inflation (If a $2 stock is worth 1 pound today, then what happens if the dollar falls 10 percent by the end of this year while the stock rises 10 percent? The stock rises to $2.20, but its value in foreign current remains the same).
The Fed’s current stance is that it is committed to rescuing the US credit markets from suffering real losses. This reminds me of the Bank of England’s stance in the run-up to Black Wednesday. Savvy investors unsure of the future value of their exposure to credit will take this as a signal to that they can only dump their own liabilities at the Fed’s expense, but can also buy under-performing loans from other investors at a discount, and then hope they can go to the Fed for the face value. This will tend to highly concentrate credit risk in the US, and to disguise the falling value of credit-based assets. Bad debts will start to to treated a little like options, with the Fed offering to trade them in for their face value. This risk is increased by the US Housing Administration’s assurance on Friday that it will underwrite delinquent loans.
As the current credit crisis shows, exposure to the risks in the US economy are widely distributed around the world both through financial instruments and through the dynamics in the current WTO talks. Even in Japan, business spending outside the software sector is starting to be curtailed. That is setting the tone for similar caution elsewhere in Asia. However, the underlying situation in Asia and Europe remains stronger than in the US, and most international stock markets are rising nicely after their normal August dip.
Of course, those risks are concentrated in the US. In contrast to some international markets, US investors face the cheapest market for a dozen years, with the average price to earning (PE) ratio of 20.8, going down to 18.4 for industrial firms. In August, the S&P 500’s PE fell to just 16.8. Cisco’s PE ratio is at 20.5, while Microsoft is at 16.6: these firms would trade even lower were two-fifth of their sales not coming in foreign currency. US investors are pretty much accepting any reasonable offer. Increasingly they are investing abroad, buying foreign assets with their US dollars, further reducing the demand for the greenback.
As we discussed in our Gartner webinar, some US firms are unable to take advantage of the increasing value of their sales abroad. Firms that use the US dollar as their international accounting currency have the impression of hugely increasing costs abroad. This motivates some firms to curtail overseas operations which are actually able to general higher profits than domestic operations. Generally, we can see the pressure for US firms to focus more on their domestic markets, while European and Asian firms expand into higher-valued currency zones the US firms may retreat from.
We see this trend already in the analyst industry, and AR managers need to anticipate similar trends in their own markets.