Dollar resurgence and emerging decline

By Jeremy Gaunt, European Investment Correspondent

LONDON (Reuters) - Investors are likely to be wrestling this week with two new factors that have arisen to complicate an already tricky environment -- a sharp about-face in currency trading and signs of trouble in emerging markets.

They will also be bracing themselves for the next wave of U.S. bank earnings, which begin in earnest next week, hoping that huge losses from the credit crisis are a thing of the past.

Weekend news of U.S. government plans to take over Fannie Mae (FNM.N) and Freddy Mac (FRE.N) will add to the mix, with all shareholders of the two mortgage giants likely to take a hit, according to an influential lawmaker.

A major financial story of the past few weeks has been the strengthening of the dollar against major currencies.

The so-called dollar index .DXY, a measure of the greenback against six other currencies, has risen in seven of the past eight weeks and is on track for its largest quarterly percentage gain since the fourth quarter of 1992.

Britain's pound has been particularly hurt by the shift, falling rapidly to levels against the dollar last seen 2-1/2 years ago, around $1.76. But the euro, too, has fallen and now trades around $1.42 compared with $1.60 in mid-July.

For equity investors, these kind of moves can have a significant impact on returns, especially in a climate of falling or weak stock markets.

"Equity investors typically don't hedge the currency risk," said Michael Metcalfe, head of global macro strategy at State Street Global Markets. He noted that at the end of 2007, U.S. investors held as much as $5.3 trillion of foreign equities.

Dollar strength would mean conversion back from euros, pounds etc, could be costly, prompting investors to try to repatriate profits in case the trend continues.

Conversely, Metcalfe also notes that a stronger dollar may put off overseas investors, including huge central banks, from buying U.S. assets. He noted that custody holdings of U.S. Treasuries had begun to fall in the past month.

"That might be the first warning sign that dollar strength will lead to slow accumulation of dollar assets by central banks," he said.

SLOWING EMERGING

A not altogether unrelated shift is also taking place on emerging markets, the once-booming asset class that is now under threat from slowing developed economies.

Friday's poor U.S. jobs data showed the U.S. economy still suffering despite some recent upbeat data.

Emerging market equities have been underperforming their developed counterparts for most of the year and are now coming under more intense scrutiny as the global downturn spreads.