Dollar’s Rally Could Be Bad Omen For U.S. Stocks Stronger Greenback Expected To Lower Corporate Profits For American Exporters

The Japanese yen took its biggest one-day plunge in two years Tuesday. Wednesday, Japan’s Nikkei 225 stock index rose more than 700 points, or 4 percent.

A coincidence?

Look at U.S. stocks. The Dow Jones Industrial Average rose more than 25 percent earlier this year to all-time highs - at the same time that the U.S. dollar was mired near post-World War II lows against the yen and the German mark. Now that the dollar’s rising, the stock market isn’t.

The Dow has slipped 2.4 percent over the past two weeks, while the dollar has risen 11 percent against the yen and 7.4 percent against the mark.

What’s happening is simple, some analysts say. The weak dollar handed U.S. exporters a windfall of foreign exchange-based profits in the first six months of the year that inflated their earnings and helped drive the stock market to record highs. Now that the dollar is rallying, those gains will ebb, taking earnings with them. And smaller profits will almost surely spell flat to lower share prices.

“We had a rally in the stock market this year because stock investors correctly saw that the dollar would stay weak for a sustained period, giving U.S. exporters a huge increase in earnings,” said Surjit Bhalla, vice president of foreign exchange at Deutsche Bank in New York.

As an added fillip to share prices, this bonanza occurred without the usual drawback a weakening currency brings - accelerating inflation driven by higher import prices. Even as the dollar slumped, consumer prices rose at an annual rate of 3.1 percent through the first seven months of the year, vs. 2.6 percent for the same period last year.

Meantime, the U.S. enjoyed the fruits of a weaker currency - chiefly faster growth than otherwise would have occurred. Though economic growth fell rapidly - from 5.1 percent in the fourth quarter of last year to just 0.5% in the second - the economy might well have tumbled into recession were it not for a 13.6 percent surge in exports in the first five months to a record $317 billion. That export boom was fueled in large measure by the sliding dollar, which made U.S. goods more competitive internationally.

Japan, by contrast, suffered mightily from the super-strong yen. As the Japanese currency soared, corporate profits evaporated and the stock market swooned. The economy, only beginning to emerge from a nearly four-year slump, stalled out once again.

The benchmark Nikkei 225 stock index fell more than 25 percent in the first six months of this year, an almost perfect mirror image of the yen’s 24 percent rise to a postwar high of 79.75 yen per dollar on April 19.

Since bottoming out on July 3, the Nikkei has rallied 27 percent - and the yen has fallen 15.6 percent. That’s got some U.S. investors turning bullish on Japanese stocks.

“The yen’s decline is very bullish for Japanese stocks,” said Michael Metz, chief investment strategist at Oppenheimer & Co. in New York.

With the dollar rebounding, the profits that U.S. corporations reaped from the plunging dollar will dry up, Bhalla said. That should take the steam out of the U.S. stock market, and give a boost to markets in Japan and Germany.

“If the dollar rallies - and it already has - the U.S. stock market should underperform markets in Japan and Europe,” said Bhalla. “My view is that one should not be in the U.S. stock market at all.”

For now, Bhalla’s bearish stance on the prospects for U.S. stocks remains a minority view.

Metz, for instance, agrees that “a lot of the improvement in the (Standard & Poors’ 500) in the first half was due to (export) translation profits.”

Yet he thinks a stronger dollar is “slightly positive overall for U.S. stocks” on the grounds that a robust U.S. currency will draw overseas investment into the U.S. In recent years many foreign investors soured on U.S. investments as they watched any gains they’d made eroded by a slumping dollar.

Other investors agree that the overall impact of a stronger dollar will be mildly positive for U.S. asset markets.

“As investors start to believe the dollar can stay stronger we could see a benefit to U.S. stocks and bonds,” said Julie Grandstaff, vice president of global fixed-interest and currency at Bailard, Biehl & Kaiser in San Mateo, Calif.

Investors cautioned against overreacting to the dollar’s rebound. While it’s up more than 22 percent against the yen and almost 10 percent against the mark since reaching postwar lows, it’s still down on the year.

“It would take an amazing strengthening in the dollar to make it a negative for the U.S. economy,” said Grandstaff at Bailard, Biehl & Kaiser. She added that a rise to 100 yen and 1.50 marks wouldn’t be enough to make much difference.

“If we went to 1.75 marks and 110 yen that might be something else,” she said.