Cash in on those overseas earners

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The Independent Online
Had you asked a few months ago where the money would be made this year, I would have given you a cocksure, dead wrong answer: the dollar, not the bond and equity markets. So far it's been none of these, which may be telling us that the next big break in equity markets will be currency-driven.

An equity market should go up when the national currency goes down, because the quoted sector of most country's markets have overseas earnings from exports and foreign business that normally are much bigger proportionally than those of the underlying economy. About a quarter of UK gross domestic product is in exports, but more than half the earnings of quoted UK companies is related to exports.

When the national currency falls and government and corporations look as though they will be able to control any negative financial effects of a weak currency upon inflation and foreign debt, equity markets rise as investors buy overseas earners as a currency hedge.

The accompanying table, provided by the Belgian broker, Petercam, shows that the devaluing countries of Europe, such as the Scandinavians, Italy and the UK, have done well in the past few years. Inflation has remained low, global market share has risen and equity investors (except in Italy) are laughing all the way to the bank. But Germany and France, the stalwarts of strong currency and tight money, are doing badly and losing competitiveness, as is Japan.

I expected European equity markets to do badly this year because fast growth in the US would raise long-term interest rates globally, as well as short-term interest rates in the US. As a result of the rise in US interest rates the dollar would rise. US investors would react by keeping more money in dollars and would send less to overseas equity and bond markets. If the yen didn't fall against the dollar, Japan's equity market would also be a casualty.

Some of this has happened, but not the dollar's rise. And what happens to the dollar is critical to the outlook for equity markets because investors are less interested in liquidity-driven equity stories than a few months ago. The focus is now on earnings and with much of its recovery already anticipated in prices, the big surprises are likely to be currency-related.

But the focus in currency markets has shifted to current account balances. Fast US growth is sucking in imports and creating a big trade account deficit.

And there is no sizeable spontaneous capital movement into the US from Japan to offset the 'natural' effect of current account imbalances that are weakening the dollar and strengthening the yen. The Japanese are keeping savings and capital at home, and others won't put capital in the US until the Fed has finished raising interest rates and depressing financial asset prices.

Europe is caught in this dilemma because our currencies are unlikely to fall unilaterally against the dollar. For the mark to weaken, the yen must fall too, and that won't happen until the Japanese economy starts to recover.

But eventually that will happen, because the mark and the yen are between 30 per cent and 70 per cent overvalued against the dollar by almost any measure. So I think that the next boom in equity markets will coincide with the break upwards in the dollar, which could take some time.

The UK equity market has been among the weakest this year. Yet domestic profits are booming, mutual fund subscriptions are rocketing and a slowly shrinking PSBR leaves institutions with more cash to put in equities. The market is depressed by the heavy weight of weak dollar earnings in the quoted corporate sector.

But the UK trade account is deteriorating as the economy (unlike elsewhere in Europe) recovers. My guess is that a deteriorating trade account will make sterling a very weak currency before long. And that's a good reason to stick to overseas earners and avoid financial and domestic utilities.

David Roche is global strategist at Morgan Stanley.

----------------------------------------------------------------- Competitive devaluations and the effect on global market ----------------------------------------------------------------- share and equity market performance 1990-93 (% change) Global Currency Equity market market share movement v BFr performance US -0.6 3.6 33.6 Canada 0.2 6.4 7.9 Japan -6.8 35.0 -55.2 Belgium 4.6 0 16.2 Denmark 1.9 1.3 1.9 Finland 17.6 -30.7 167.9 France -6.7 -0.7 14.0 Germany -10.7 1.0 24.9 Italy 9.7 -21.2 -9.9 Netherlands 1.2 1.3 37.7 Spain 21.7 -17.0 8.5 Sweden 11.8 -21.3 12.6 Switzerland 3.5 -2.8 66.3 UK 5.0 -12.7 40.4 ----------------------------------------------------------------- Source: Pet ercam -----------------------------------------------------------------