Falling US dollar and its impact on stock
markets
13 October 2003
After a pause in September, most major stock markets have resumed their advances, indicating that the global equity bull market is still intact. Whether the bull market will be sustained, however, depends very much on how global economic imbalances are redressed, and in particular, on how the US dollar performs.
In the US, the Standard & Poor's 500 rose 0.8 percent to 1,038.06 last week, its third weekly gain in four. In the same week, the Nikkei 225 rose 0.7 percent to 10,786.04, also its third weekly gain in four. In Singapore, the Straits Times Index rose 4.5 percent, its fourth successive weekly rise -- and the biggest weekly gain in four months -- closing at 1,746.04, its highest level since May 2002.
The equity bull market has been driven mainly by world-wide economic recovery, corporate earnings growth and liquidity. Latest economic indicators suggest that this trend will continue for a while more.
The problem, however, is that global economic imbalances remain. The US faces deficits in its budget and current account. High debt levels are pervasive in its corporations and households. Asia faces deflation and competition from China, which itself has to grapple with the dilemma of economic reform, property speculation and currency revaluation pressure from developed nations.
Currency re-alignment, in particular, may have an important bearing on economic and investment dynamics over the next few years. In the aftermath of the bubble of the late 1990s, the US economy has been remarkably resilient. This has been largely due to the buying of US fixed income paper by Asian central banks in an attempt to prevent their currencies from appreciating against the US dollar. This has helped keep interest rates in the US low, which in turn has supported US consumption of Asian manufactured goods.
However, persistently high unemployment in the US has forced the US government to confront the consequences of the over-valued US dollar arising from Asian buying of its currency. In contrast to earlier administrations, President George Bush's government has tolerated a weaker US dollar and urged Asian countries like China and Japan to allow their currencies to float according to market forces. At the recent Group-of-Seven meeting, the finance ministers made a similar call for exchange rate flexibility to address global economic imbalances. And just yesterday, at the World Economic Forum's East Asia summit in Singapore, International Monetary Fund deputy managing director Shigemitsu Sugisaki said: "Greater exchange-rate flexibility in Asia should be part of a gradual process of reducing global current-account imbalances".
The consequences of a weaker US dollar and stronger European and Asian currencies are difficult to predict. Some observers fear that stronger European and Asian currencies mean greater deflationary pressures in these economies. Others suggest that currency re-alignment would force European and Asian economies to restructure and reflate their economies through increased consumption, especially for the latter. This would shift the drivers of economic growth away from the US and toward Asia and Europe and help rebalance global current accounts.
A weakening US dollar would also have an impact on capital flows. Fears of a weaker US dollar would encourage investors to move funds to other markets. Already, many investors are trying to position themselves for a possible renminbi revaluation.
However, the impact of a weaker US dollar on Asian equity markets is not so straight-forward. There is a possibility that capital would be diverted from the US and be invested in Asian stock markets. However, fundamentally, Asian companies would be faced with reduced export competitiveness. Asian economies that cannot be successfully restructured to absorb the increased currency strength with increased domestic consumption may not prove attractive enough to equity investors.
While currency issues could have a major impact on stock markets eventually, in the near term though, liquidity and positive sentiment from the ongoing global economic recovery are likely to continue to push most stock markets up.
Stock market valuations, while not exactly low, are also not obviously high. In the US, S&P 500 stocks are trading at about 18 times forward earnings, while in Singapore, STI stocks are trading at about 16 times forward earnings.
However, with earnings growth likely to decelerate next year, most of the gains from the current bull market have probably already been made. I had suggested in an earlier article that the STI is likely to peak between 1,800 and 2,000. Even as the market approaches the former target, I see no reason to change my view.
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