Anathema? A strong dollar could lift Dalal Street

A strong dollar could well lead the equity markets higher this year.

The US appears to be the best among major economies, which has helped the US equity markets and the dollar emerge as the best performers since the beginning of August 2011.

August 2011 was the month when debt problems in the euro zone and inflation issues in India and China hit peaks, leading to the beginning of a collapse of equity and currencies across the world.

US markets stand out in the return comparison above and the reason is that the US economy has progressed in the last eight months. The economy has added 1.2 million jobs in the last six months, the highest in any six-month period since 2006, while its unemployment rate has fallen to 8.3% from around 9.5%. The US Federal Reserve has maintained rates at zero percent levels but it has refrained from carrying out a third quantitative easing programme and has instead been replacing short-dated government bonds with long-dated government bonds (operation twist) to bring down long-term yields in the economy.

The performance of currencies reveals that the US economy is doing better than other economies. The euro has lost 8.5% against the dollar over the last eight months as sovereign debt issues facing the euro zone have prompted the European Central Bank, or ECB, to pump in huge amounts of liquidity into the system. The ECB has infused €1 trillion of liquidity through long-term refinancing operations in order to stabilise bond yields of indebted nations of Italy and Spain. The euro zone is seeing mild recession on the back of austerity measures adopted by euro zone nations to bring down debt, with fourth-quarter gross domestic product, or GDP, showing negative growth.

The rupee has lost 13% against the dollar on the back of a widening current account deficit, which has gone up 1% in 2011-12 against 2010-11 and on the back of a slowing economy due to high inflation and high interest rates. India’s GDP growth fell to 6.1% in the third quarter of 2011-12 from 6.9% and 7.7% levels seen in the second and first quarter, respectively. India faced inflation of over 9% for most of calendar 2011, prompting the Reserve Bank of India to raise policy rates for the whole of fiscal 2010-11. India has forecast growth at 7.6% for 2012-13, below trend levels of over 8% seen in most part of the 2000 decade.

The Japanese yen, which benefitted from risk aversion trades in 2011 and trended down to decade highs of 75 to the dollar, has lost around 8.5% since August 2011. The fact that the Japanese economy is still recovering from the March 2011 earthquake has prompted the Bank of Japan to increase its bond purchases by $130 billion. Japanese interest rates are the lowest in the world with ten-year bond yields at around 1% levels.

Chinese equities have borne the brunt of the property bubble in the country and the government’s efforts to curb the bubble. China’s GDP growth forecast for 2012 is at 7.5%, the lowest since 1999, and the government is committed to reining in property prices. Bank lending, which has driven property prices to all-time highs in China, has threatened the balance sheets of Chinese lenders as prices appear to be dropping. China also faced its highest trade deficit since the late 1980s on the back of weak exports as economies in the euro zone and Japan faced headwinds.

A rising dollar will be positive for equity markets as it signals an improving US economy rather than risk aversion trades. 

However the equity rally will have a different face as the commodity markets struggle in the face of a strong dollar and in the face of economies of China, India and the euro zone growing at below trend levels.

Investors should analyse what a strong dollar means for different sectors and then look to invest in those sectors.

The writer is editor, www.investorsareidiots.com, a website for investors.