The recent realignment of the euro with the dollar has created clearly defined winners and losers in the Eurozone equities market. The winners are companies that import their raw materials from outside the Euro-zone while the losers are companies like semiconductors that export outside the Euro-zone.
Catherine Reilly, chief economist at Pohjola Asset Management in Helsinki, says: “The market is now beginning to differentiate between the exporters which will be affected by the weakening of the euro and some domestic sectors which stand to gain. Some companies like a Finnish steel company which basically pays for its imports in US dollars but then sells most of its products in European markets should actually benefit from the fact that its cost structure will be come lighter.
“Obviously the realignment is not particularly good news for Euro-zone exporters and we’re seeing definite price declines among them. If you look at forestry, metals and engineering companies in Finland that export outside the Euro-zone they are definitely not doing particularly well at the moment.
“The more domestically oriented a sector is the less impact it will feel from a currency depreciation. Retail for example should be relatively unaffected and in theory could stand to gain because the appreciation of the euro will increase purchasing power in Europe because it will dampen inflation pressures.”
A depreciating dollar will have a significant effect on European profitability both this year and beyond, according to Deutsche Bank’s team of European strategists. Their analysts have estimated the impact of the depreciating dollar on the earnings before interest and taxes (EBIT) of 359 non-financials companies in the Euro-zone. They estimate that for European listed corporates overall a 10% drop in the US dollar translates into a 4.7% drop in EBIT. The sectors that are likely to take the largest hits are technology, industrials and cyclicals. Semiconductors score worst with a fall of 42% in EBIT.
At the other end of the scale, the least affected sectors are headed by steel, where a10% fall in the dollar would mean a 1% rise in the EBIT of steel companies. This reflects the considerable effect of their dollar-denominated purchasing of raw materials, mainly iron ore and coal. The media sector also shows a positive gain of 0.7% in EBIT, mainly due to the presence of Vivendi. Domestic sectors such as property and retail area also unaffected.
How this is likely to feed through to profits has been calculated by analysts at Commerzbank Securities. Autos sector analysts have concluded that a 10% fall in the dollar would knock $1.7bn off the profits of the big four German manufacturers.
Commerzbank economists Peter Dixon and Tamiko Bayliss warn that the realignment of the euro to the dollar will hit economic growth as well as company profits. They point out that standard simulation results calculated by the OECD suggests that a 10% appreciation of the euro can be expected to reduce GDP by 0.6 percentage points in the year following the move. This year the euro has appreciated 7.5%. If it stopped rising further today this would knock almost 0.5 percentage points off growth over the next 12 months. “Given the anaemic state of the economy at present, this is a considerable amount to lose. ”
They suggest that the euro’s appreciation against the dollar despite economic weakness in the Euro-zone can be explained partly by the market’s disappointment with GDP growth in the US, almost two percentage points below market perceptions of trend. However, another reason is that portfolio investment is flowing back into the euro area after big outflows in 1999 and 2000, mainly because European companies are withdrawing their funds from the US, having invested heavily during the boom.”
The unanswered question is how far will the dollar fall. Since January last year the dollar has been falling very markedly losing 23% to the euro. In the year to date, the euro has appreciated by 9% against the dollar and recently the trend has accelerated Michael Rosenberg, foreign exchange analyst at Deutsche Bank believes the dollar has much further to fall. He predicts that the dollar will overshoot to the downside reaching 1.20 versus the euro over the next 12 months and 1.45 in the next 18 to 24 months.
“This means that forecasts of earnings are likely to be far too optimistic,” says Pohjola’s Reilly. “Analysts have made their forecasts assuming that an average exchange rate of maybe 1.05 at the maximum, and it looks like they’re going to have to make considerable adjustment to forecasts which is going to have a noticeable impact on revenues.
The speed of the realignment has taken everybody by surprise, she says. “Everybody has been expecting a realignment of the exchange rate. But the speed of it and the fact that it’s also been a very asymmetric realignment is a surprise – it’s just a dollar/euro realignment and Asian currencies aren’t affected.”
All eyes are now on what happens in the US. Here the worry is that the economy is head for deflation. The Federal Reserve issued a warning on 6 May about the risk of excessive disinflation, combined with April’s inflation figures, which fell to a level unseen since the 1960s – overall inflation 2.2% and core inflation of 1.5%
This has produced the paradox of a disinflationary spiral and a depreciation of the
currency, says Reilly. “You have the interesting development that they’re incredibly worried about deflation despite the fact that the currency has lost a substantial share of its value over the past year. That’s normally a fairly inflationary situation.” But, then, these are far from