CreditSights: The Week In Credit
One development that has caught our attention of late is how well the equity market is withstanding the latest sustained bout of dollar weakness. Dollar weakness and equity market strength make strange bedfellows. For U.S. investors, a declining dollar is usually coincident with economic stress, low risk appetite and a propensity to put money in safer fixed-income assets at the expense of equities. For foreign participants, a weak dollar means lower returns. Now that the war-related relief rally in equities is a couple of months old and the dollar is still showing no signs of reversal, we can't help but wait for the other shoe to drop. Bucking the trend is all very well, but a sustained divergence would make a lot more sense if there were more positive signals from the economic data. A consistent rhetoric from Washington would also make more sense. Treasury Secretary John Snow has vocally endorsed a strong dollar position, but recently commented on the benefits of dollar depreciation on exports. It is increasingly obvious that, notwithstanding the strong dollar mantra that has been repeated over many years, some depreciation is acceptable particularly since the economic impact from an inflation perspective is tolerable given prevailing disinflationary trends.
For U.S. corporations, any positive effect from dollar weakness will be strengthened by the accompanying decline in energy prices. Manufacturing companies will be in a more favorable position to sell products overseas conditional on sufficient demand. The position of firms with large offshore production facilities that have historically derived the competitive advantage from lower production costs is less straightforward. Assessing sharp moves between major currencies has always been a difficult task with respect to gauging the impact on major corporate issuers. Disclosure does not always allow the outside analysts to clearly sort out and quantify the risk that is more of cosmetic nature (translation risk and financial reporting) from that clearly of an economic nature (cash margins and erosion of asset protection). That being said, major industrial issuers feel the immediate impact of currency moves in the competitive pricing of their products across end markets. They feel it even more directly when the products are dollar denominated (or benchmarked off of dollars) and direct production costs are non-dollar.
We already have seen the metals producers in particular looking to address hedging strategies to ease the risks of expected dollar moves prior to the war with Iraq. In the chemical industry, dollar and hydrocarbon-based feedstocks thicken the plot around the petrochemical margins and competitiveness of European operations. The manufactured goods sector will also be impacted with respect to finished good pricing and competitiveness in export markets. Bondholders should note that the currency swing has been coming up regularly in Q&As on earnings calls for many of the companies in these industries, and disclosure varies considerably in the area of quantifying cash flow and earning sensitivity to exchange rates.
Perhaps more worrisome to the corporate sector is the potential impact on capital account flows as dollar weakness discourages foreign investment in U.S. assets, making it more difficult to finance the U.S. current account deficit. Fed data indicates that foreign purchases of U.S. corporate debt remained strong through February, but it is likely that foreign demand has weakened since then. Our model on foreign purchases of U.S. corporate debt shows a decline in estimated purchases in March and April and continued dollar depreciation, combined with lackluster economic performance could drive foreign funds away going forward. With over 20% of U.S. corporate debt residing in foreign hands, that clearly is a development for domestic bondholders to watch closely.
Analysis by CreditSights, Inc., an independent online credit research platform. Call (212) 340-3888 or visit www.CreditSights.com for more information.