How King Dollar Changes Everything

3/18/2015 – After a historic 6-year stock rally, this may be the unanticipated event that slows the U.S. stock market advance. The US Dollar started its impressive rally back in July 2014 when investors were contemplating the end of QE. The USD rally is the longest in history and the index is up over 25% since.

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What does this mean for U.S. companies? What about U.S. consumers? For U.S. companies, it’s difficult to say, but a strong dollar can seriously impact earnings growth. We may soon find out once companies begin reporting Q1 earnings next month. For people like you and I, it makes imported goods cheaper and international travel lighter on the wallet.

What caused the Dollar to rally?

In short, this rally was caused by the ending and the continuation of monetary easing in the U.S. and the rest of the world, respectively. While the U.S. was wrapping up QE last year, Europe, Australia, China, Japan, etc. was continuing (and enhancing in some cases) to ease their monetary policy. Remember, when a government enters into quantitative easing, the net effect is to reduce yields on their own bonds. The idea is to make lending cheaper and to force investors to look to riskier investments for greater returns (e.g. stocks). Governments accomplish this by issuing more bonds and by having a large buyer purchase those bonds. The large buyer, in this case, is the government itself with “printed” money. Here in the U.S., the Fed purchased Treasury-issued bonds with newly Fed-created dollars. By having consistent, strong demand for these bonds, U.S. yields were depressed.

But how does QE impact exchange rates? Here is are two explanations:

  1. When the U.S. launched QE, the Fed purchased government bonds with “printed” U.S. Dollars. This is a simple exercise of supply-demand. When the number of U.S. Dollars increased, the value of the U.S. Dollar is declined. It is analogous to increasing the number of outstanding shares for a company. It dilutes EPS.
  2. Let’s say an international investor (e.g. a German citizen) is looking to receive the same bond return from both a German Bund and a U.S. Treasury bond. If the investor were expecting a return of 2% and the quantitative easing resulted in the bond price to increase by 10%, then the effective yield would decrease from 2% to 1.8%. The investor would then expect his currency to appreciate 10% to bring his expected return back up to 2%.

The Relationship between the U.S. Dollar and Oil

The oil crash is well known and well documented. There are many factors that affect the price of oil (e.g. elasticity of demand, OPEC, geopolitical issues, American shale, etc.). Likewise, there are many issues that affect the U.S. exchange rate (e.g. differential in inflation, public debt, trade, economic performance, etc.). Yes, oil prices affect all countries, markets, consumers, etc. But the crash is not completely due to oversupply/under-demand. There is certainly an oil glut and demand has not been able to keep up with the oversupply. However, what is not well known is the negative correlation between the USD and oil.

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Recently, there has been a strong negative correlation between the two: as the dollar surges, oil prices fall and vice versa. Because the USD is the world’s reserve currency, oil is traded in USD. While the dollar can influence oil prices, oil prices can also affect the value of the USD. This is a very complex relationship, though one cannot definitively say if one has more influence over the other. It is interesting to note is that this phenomenon is relatively new. It seems to have begun in 2000 where it was not present for the three decades before. According to a paper written by Fratzscher, Schneider, and Robays at the ECB, “A 10% increase in the price of oil leads to a depreciation of the US dollar effective exchange rate by 0.28% on impact, whilst a weakening of the US dollar by 1% causes oil prices to rise by 0.73%.”[1]

How A Strong Dollar Can Affect the S&P 500

As we all know well, the U.S. economy is globally connected. What happens overseas can affect U.S. companies earnings. What is not known is how interconnected we all are. With a surging dollar, the global competitive landscape is changing before our eyes. For some businesses, it is becoming increasingly more difficult to compete against their European/Japanese/etc. counterparts. For others, it is helping with their competitive advantage. It is now cheaper to outsource manufacturing and drive margin expansion. So, which is more beneficial to the overall economy? So far it looks as if a surging USD damages more than it benefits U.S. companies. During Q4 2014 (Oct – Dec), the US Dollar Index appreciated 6.5%. During the same time period, S&P 500 earnings fell by 14%. Will earnings continue to fall in Q1 2015? Nobody knows. However, it is worth noting that the USD has increased by 9% so far this quarter.

What a Strong Dollar Means For U.S. Consumers

So far, this newsletter has been a bit dismal, which is atypical for me. But let us not forget how a strong USD bodes well for the American consumer! Not only is gas cheaper, but also so are the prices of many other goods. Recent CPI data certainly reflects the drop in oil prices. Everyday items are cheaper, which allows for U.S. consumers to either save or to spend more. According to a 2011 San Francisco Fed study, 13.9% of all U.S. goods and services come from abroad.[2] That is a significant amount! Additionally, import costs have declined for 7 straight months. Have these savings been passed along to U.S. consumers? Yes, there is evidence of apparel prices falling. Will it continue as the USD continues to appreciate? One would think that some of those savings will eventually be.

And finally, if you are the traveling type, there is no better time to visit Europe, Japan, Canada, Australia, and elsewhere! So while U.S. companies may be affected by a surging dollar, U.S. consumers are most certainly going to benefit from it. While companies have already experienced an economic recovery, it’s about time that the U.S. consumers also realize one. This may finally be that moment.

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[1] http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1689.pdf

[2] http://www.frbsf.org/economic-research/publications/economic-letter/2011/august/us-made-in-china/
 

Ryan Hughes
Bull Oak Capital
Bull Oak Newsletter
3/18/2015


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