The greenback gremlins are stalking UK plc

The City has returned to work in a chipper mood. The FTSE is up and traders, bankers and fund managers are talking of further recovery in the stock market this year.

But the optimism may be misplaced. A threat is lurking that could undermine any hope of strong growth in companies' earnings. It's the dollar, now at an 11-year low against sterling.

The weakness of the greenback is a threat to some of Britain's biggest companies. Just over a quarter of sales generated by FTSE 100 companies are denominated in dollars, and although the City has yet to cotton on fully, earnings from the likes of GlaxoSmithKline, Hanson and Anglo American are at risk.

Robert Parkes, a strategist at HSBC Securities, says: "The weaker dollar will certainly have a negative impact on UK corporate profits. We are forecasting 10 per cent earnings growth for the UK market in 2003, against consensus estimates of 16 per cent. The difference is largely attributable to the currency effect."

British companies with large American subsidiaries are the most exposed. GlaxoSmith-Kline, the UK's fourth largest company, makes more than half of its profits in the US. "Glaxo is a major dollar earner so it will be hit by the translation of US profits into sterling," says Peter Cart-wright, an analyst at stockbroker Williams de Broë.

Hanson, the FTSE 100 building materials company, has similarly heavy US exposure: like Glaxo, it generates more than 50 per cent of its profits in the US. It has warned that it will take a £20m currency hit in 2003, as the average sterling/dollar exchange rate fell to $1.63 compared with $1.50 in the previous year. Should the exchange rate hold at the current $1.8477 level, profits could fall by another £30m in 2004.

Invensys, the engineering firm currently struggling for survival, is in much the same predicament. Nearly 70 per cent of its sales are in the US. What's more, the company is in the middle of selling various US businesses to reach its target of raising £1.8bn, which it needs to pay off its debts.

On Friday, the retailer GUS became one of the first companies to have its earnings estimates downgraded because of the weak dollar. Investment bank JP Morgan trimmed 2.1 per cent as a result of GUS's Experian business, which is heavily exposed to the US.

Another worry for the City is that the weaker dollar could lead to lower dividend payments. Some of the UK's biggest companies, including BP, HSBC and Anglo American, pay their dividends in dollars, and British investors will, therefore, receive less income in sterling terms. In fact, companies reporting in dollars account for more than a quarter of the stock market's total value, and if these firms disappoint, the FTSE could be heading for a fall.

The weak dollar will have a negative impact on the mining and oil industries, with commodities priced in dollars. The concern about companies such as Anglo American, BHP Billiton and Rio Tinto is not so much the translation of dollar sales, but the potential for a mismatch between dollar income and non-dollar costs. With the value of sales falling and costs rising, profits are under pressure.

"A weak dollar will erode profit margins because labour costs, power costs, etc will be denominated in local currencies such as the South African rand and the Australian dollar, which have strengthened in recent months," explains Nick Hatch, an analyst at stockbroker Investec Securities. "With commodity prices at multi-year highs, you'd think that these mining companies would be doing very well, but this is not the case."

The smaller oil exploration companies, such as Paladian Resources, could be particularly hard hit. Many of Paladian's operating costs are in sterling and the Norwegian kroner, while the oil it produces is priced in dollars, leading to a squeeze on profits.

The UK companies that will feel the most immediate pain from the weak dollar will be those exporting to the US. While they may not always hit the headlines because of their relatively small size, there is an army of firms struggling to sell their wares into the American market. Vitec, for example, which has a market capitalisation of £142m, makes photographic equipment. One of its biggest markets is the US, but it is suffering from a double currency whammy as it manufactures in the UK and also in Italy, where the euro is at an all-time high against the dollar.

"It's a major headache for us," admits Vitec's finance director, Alastair Hewgill. "We just have to keep grinding away at our cost base. I've been in business 30 years, and this is the third time this has happened. We have to take a long-term view that the dollar will come back round again."

Another UK industry praying for the dollar to rise is leisure. American tourists, already spooked by airline security, will be less inclined to holiday in Europe because their dollars won't stretch as far. Companies such as InterContinental Hotels could be vulnerable, according to Simon Larkin, an analyst at investment bank ABN Amro.

But not everyone is cursing the weak dollar. British retailers are likely to benefit from a reduction in the cost of products bought from dollar-based Asian economies. In particular, Next, Matalan and George at Asda source many products from these markets.

Companies buying software and computer products - a market dominated by US suppliers - could also benefit. Enzo Tolino, UK finance director of Sun Microsystems, says: "Our products are priced in dollars and then converted into pounds. We review prices every quarter so, given the long period of the dollar weakness against the pound, customers are getting a better deal."

But these benefits to British companies are unlikely to offset the anticipated decline of earnings resulting from the weak dollar.

If the City has yet to fully account for the impact of the fall in the dollar, many bankers will become acutely aware of the issue in the next few weeks. It's bonus season at the investment banks, and after a strong run in equities, many in the Square Mile are looking forward to a handsome reward. But there's a snag for anyone working at a US investment bank: bonuses are priced in dollars, not sterling.