Is Weak Dollar to Blame for Stocks’ Slide?
Fishing around for a reason why the stock market has run out of gas, some Wall Streeters have dredged up an old bogyman: the sliding dollar, with its potential implications for higher inflation and interest rates.
Commenting on the Dow industrials’ five-day slide last week--a loss of 64.84 points to 3,413.77--veteran market analyst Hugh Johnson at First Albany Corp. in New York cited “a deep concern about the decline in the dollar.”
In recent weeks, the dollar has tumbled to one record low after another against the Japanese yen, closing Friday at 110.50 yen in New York, down from 124.80 at year’s end.
But until now, stock and bond markets have largely ignored that plunge and the dollar’s smaller decline against other major world currencies this year.
When Barron’s magazine recently asked money managers nationwide to name the “biggest investment threats” for the next 12 months, the weak dollar rated dead last of a dozen threats mentioned. Only 6.2% of the managers cited the dollar. The No. 1 threat: higher taxes, mentioned by 63.6% of the managers.
Charles LaLoggia, a Rochester, N.Y.-based analyst who writes the market newsletter Special Situation Report, notes that investors’ uncaring attitude toward the dollar’s plight suggests that that is where the greatest potential for disappointment lies. “To me, a dollar crisis is one of the major dangers for the stock and bonds markets in 1993,” he says.
Why should markets care about a weak dollar? After all, the greenback’s decline is hardly a new theme: The dollar has been dropping against most key currencies since 1985, when the world’s industrial nations began a concerted effort to cheapen the U.S. currency--thus lowering the prices of American exports abroad and narrowing America’s huge trade deficit.
The plan has worked better than most experts would have bet. “Smokestack America now is more competitive (with foreign manufacturers) than at any time since the 1960s,” says Stephen Roach, economist at Morgan Stanley & Co. in New York.
The Clinton Administration, recognizing that success, has used dollar-bashing as a key weapon in its fight to open new markets for U.S. goods in Japan--the trading partner that still draws the greatest criticism for its alleged protectionist policies.
But while the dollar’s latest drop has unquestionably helped some U.S. manufacturers sell more abroad, some economists say a lower-dollar policy has reached the point of diminishing returns.
What’s more, Wall Street was expecting a stronger, not weaker, dollar in 1993. A recovering U.S. economy and steady interest rates were supposed to bolster our currency, while the yen and European currencies were supposed to weaken as those economies ebbed and as interest rates abroad fell.
With last week’s stock slide, First Albany’s Johnson believes that investors may finally have begun to focus on the negative aspects of a falling dollar: the threat of higher inflation and higher interest rates.
While a weak dollar makes U.S. goods less expensive overseas, it also automatically raises the prices of goods we buy from foreigners--goods that account for about 11% of our economy. Already this year, Honda Motor Co. has twice raised prices on cars it ships from Japan to the United States.
Foreign price hikes also make it easier for domestic manufacturers to raise their prices, which is especially tempting at a time when many are looking to bolster profits after several lean years.
Import price hikes haven’t yet had a significant impact on U.S. inflation, but some analysts worry that the worst is yet to come. And because the stock and bond markets are now so acutely attuned to inflation--after the recent scare from surging commodity prices--there is a risk that even a small perceived increase in inflation could cause a flight from stocks and bonds.
Allen Sinai, economist at Boston Co., argues that the inflation threat from imported goods is still minor. “Even with a 10% decline in the dollar from here, I don’t think the added inflation would be more than a half-percentage point or one percentage point,” he says.
Yet with inflation expectations almost universally at 3% for 1993, even a rise to 3.5% could dramatically alter many investors’ comfort level with stocks and bonds.
Far more troubling is the weak dollar’s threat to interest rates. With the economy slowing, many investors’ expectation is that the Federal Reserve will be forced to ease credit again by summer.
But a Fed rate cut now could send the teetering dollar tumbling, some experts say. The dollar’s value, after all, is a function of the relative returns on U.S. bonds and money market instruments versus yields available overseas. Cut U.S. rates again and you encourage more foreigners to pull their money from U.S. investments and hunt for higher yields elsewhere--say, in Germany. By definition, when money leaves U.S. markets, dollars are sold--driving the currency lower.
So what happens if the economy continues to soften? Analyst LaLoggia sees the Fed in a no-win situation. If the Fed fails to cut interest rates, the economy gets weaker, which by itself is a dollar depressant.
Or, says LaLoggia, the Fed could succumb to political pressure to cut rates, sparking a new plunge in the dollar and causing a massive flight of foreign capital from U.S. financial markets.
In perhaps the worst-case scenario, the Fed would be forced to raise interest rates to defend the dollar. With stock prices near record highs, and bond yields near record lows, any tightening of credit by the Fed would cause absolute carnage in the markets.
Of course, things don’t have to play out this way. Indeed, Morgan Stanley’s Roach believes that the dollar’s latest slide is nearing an end. “Going to 105 yen is possible, but anything else is a stretch,” he contends.
The bullish case for the dollar (and U.S. stocks and bonds) goes like this: The U.S. economy continues to expand, albeit moderately. The Europeans and Japanese continue to cut their interest rates, making our stable rates more attractive, thus luring more investment here.
And as the dollar rallies from that cash inflow, it feeds on itself--because a rising dollar automatically boosts the value of foreigners’ investments here, motivating them to invest more.
The problem with that rosy scenario is simply that it was supposed to unfold over the last four months, but didn’t. What worries some experts now is that the weakness in stocks, and the continued rise in the price of gold (the last safe haven), are early warning signs that a dollar crisis is brewing.
While Roach doesn’t believe that talk, he admits it’s potentially troubling that most Wall Streeters haven’t yet focused on the what-ifs. “I think investors are totally unprepared for a dollar that really surprises on the downside from here,” he says.
The Dollar’s Trend: Mostly Down The dollar’s value against key foreign currencies, one year ago, at year-end 1992 and as of Friday:
Year Change vs. Dollar in: ago Dec. 31 Friday Dec. 31 Japanese yen 133.11 124.80 110.45 -11% British pounds 0.563 0.660 0.635 -4% Swiss francs 1.530 1.466 1.428 -3% French francs 5.576 5.517 5.343 -3% German marks 1.654 1.619 1.582 -2% Canadian dollars 1.196 1.271 1.261 -1% Italian lire 1,243.00 1,473.00 1,489.00 +1% Spanish pesetas 103.60 114.50 117.05 +2%
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