Dollar's strength blamed for sluggish sharemarket March 28, 2011 The sharemarket is another indicator of the stultifying

impact the high Australian dollar and caution among households and businesses are having on the economy. Australias sharemarket has underperformed over the past year, with the underperformance worsening since last August, according to UBS Securities Australia strategists David Cassidy and Dean Dusanic in a strategy note. Not only has the local market underperformed global equities in local currency terms, the same can be said for each of its most important sectors. Advertisement: Story continues below And it all comes down to the most basic of equity market fundamentals: earnings. Our analysis suggests that Australias core problem has been a relatively weak earnings performance versus both global and regional equities, the UBS strategists say. That sub-par earnings performance has two causes. One is the strength of the Australian dollar. The other is the below-trend activity levels in many of the sectors with a presence in the market for listed securities. They dismiss the argument that the relative underperformance has been the result of high valuations a year ago. While share prices relative to earnings were relatively a little higher in Australia a year ago, that was mainly the result of richly priced mining stocks, and mining has outperformed the other sectors in the past 12 months. The Australian sharemarket typically outperforms the rest of the world when the Australian dollar is rising. But the underperformance since the start of 2010 suggests perhaps the $A has reached a choke point for the economy/earnings cycle, or that economic activity is currently weaker than in other periods of $A strength. Either way, earnings are at the core of the problem. In 2010, earnings per share in Australia grew by 11 per cent, compared with 40 per cent in the rest of the world. Moreover, excluding the resource sector, Australias calendar year 2010 growth was an anaemic 5 per cent compared to 38 per cent for the world, say Cassidy and Dean.

Whats more, expected earnings have been downgraded for Australia stocks over the past year by 3 per cent overall and 9 per cent aside from the miners, while rest-of-the-world earnings expectations lifted by 2 per cent. Cassidy and Dean nominated the strong Australian dollar - boosted by the renewed strength of commodity prices as Earnings Culprit No. 1. Of the top 100 non-resources stocks, they estimate that 25 have significant foreign currency earnings, mostly commonly the US dollar. Sluggish earnings growth and persistent earnings downgrades have been prevalent in this segment of the market, though the impact of the currency is often difficult to disentangle from macroeconomic conditions or stock-specific factors, they say. Earnings Culprit No. 2 is weak activity, the effect of tighter monetary policy from the Reserve Bank of Australia (RBA), a desire on the part of households and businesses to reduce their reliance of borrowing, the effect of the strong Australian dollar on activity in import-competing industries. They also suspect uncertainty over government policy - notably the carbon tax and the new resources tax - might be suppressing activity. The question remains whether the economy is succumbing to the so-called Dutch Disease, sometimes known as the Gregory effect, named after the economist and former RBA board member Bob Gregory, who outlined the effect of minerals booms on non-resources sectors of the economy.But the arrival of this two-speed economy has been somewhat premature, they say. Their preferred explanation for the current flat spot is a temporary mid-cycle slowdown caused by earlier monetary policy tightening and caution among households and businesses. It is quite likely that the economy regains momentum again before ultimately succumbing to the two-tiered curse.