Investor - An insider's guide to the market: Gyrations in foreign exchange rates have become an increasing focus of attention over the past year due, in large part, to the emergence of persistent weakness in the foreign exchange value of the dollar.
Although equity markets have generally regained their poise in 2003, overall volatility in financial markets has remained quite high due to an increase in volatility in global bond and currency markets. Financial imbalances in many of the world's major economies are at the heart of large swings in the prices of bonds and currencies.
In particular, the US economy is running an enormous deficit, which shows no sign of diminishing, on the current account of its balance of payments. Also, the impact of large tax cuts combined with the slowdown in growth up to mid 2003 is leading to a very large increase in the federal government's borrowing requirement.
The burgeoning US trade deficit has become an increasingly important factor in the decline in the trade-weighted dollar exchange rate over the past 12-18 months. At the end of the first quarter of 2002, €1 bought $0.87. At today's rate, €1 will buy $1.18 - representing a cumulative euro appreciation of 36 per cent.
The euro has appreciated from a rate of $1.05 at the end of 2002 to the current level of $1.18. In recent weeks, the dollar staged a recovery towards the $1.14 level but this proved short-lived.
From an Irish perspective, the strengthening euro has come at a time when the economy is adjusting to the post-Celtic Tiger era. The strengthening euro is putting pressure on the State's competitiveness outside the euro zone.
But it is a double-edged sword since the stronger euro is already playing a very important part in reducing the domestic rate of inflation. Also, although the US is a very important trading partner, Britain accounts for a much higher proportion of external trade. Therefore, the euro-sterling exchange rate has an even larger impact on the State's international competitiveness.
In the past sterling has tended to behave as a halfway house between the dollar and the euro. The past 12-18 months have been no exception, as evidenced by the rise in the euro-sterling exchange rate from 61p to the current level of 70p - equivalent to euro appreciation of 15 per cent.
For those who still like to think in terms of the old pound-sterling exchange rate this is equivalent to a rise from Ir£0.78 to Ir£0.90.
Recently, sterling has begun to trade more strongly on the foreign exchange markets and this relative strength has undoubtedly been aided by the recent rise of 0.25 per cent in official interest rates. All of the signs are pointing to further rises in UK short-term interest rates early next year.
In stark contrast, the US Federal Reserve has stated that US interest rates will stay low for quite some time. Therefore, sterling may well hold its own on the F/X markets for the foreseeable future.
For many companies quoted on the Irish Stock Exchange, movements in sterling and the dollar have a significant translation impact on profits. For those companies with substantial UK operations, the worst may be over if sterling remains firm on the F/X markets. However, those companies with substantial dollar earnings are at risk of further profit downgrades due to dollar weakness.
The most exposed quoted Irish company to dollar weakness is Waterford Wedgwood, which generates most of its sales in dollars. With a high proportion of its cost base in Europe, the depreciating dollar is putting a severe squeeze on profitability.
Other companies with substantial US exposure include AIB, CRH and Kerry Group. The weakening dollar is having a depressing effect on the profit growth of these companies but the negative impact is relatively modest.
Companies such as CRH and Kerry incur a significant proportion of their costs in dollars and, over time, this acts as a natural hedge to any adverse exchange rate movements.
With most commentators expecting further dollar weakness, investors need to take into account the dollar exposure of quoted firms.
However, in most cases, any negative impact from currency movements will be short lived and the performance of the underlying business activities will be the ultimate arbiter of share price performance.
