Despite the fact that being strong is usually considered much better than being weak, there is a lot of concern about the strengthening of the U.S. dollar and its effect on our economy, companies and consumers. We’ve benefited from a weakening currency for several years now, so a reversal naturally causes concern. In this issue, we ask DeAnne Steele, investment executive for the western United States at U.S. Trust, to explore how the dollar’s move may affect these various indicators and how U.S. Trust incorporates their outlook into its forecasts and into its clients’ portfolios.
Why is the U.S. dollar
There are many reasons, but a big one is that our economy is growing more than others around the globe, and our recovery from the recession is in a more advanced stage. This is causing very different monetary policies around the world.
Let’s consider monetary policy. Europe is embarking on a quantitative easing (QE) program designed to buy more than 1 trillion euros of bonds. Japan has a foot on the accelerator. China is easing. In fact, there have been over 500 easing moves around the world since last year, bringing down global rates. This leads to assets from overseas coming into our country to buy bonds, stocks and real estate. With more money coming in than going out, our currency strengthens.
How do the world’s actions affect the dollar?
Europe, for example, is fighting deflation, which could lead to a triple-dip recession. As concern grew that their economy was going to contract, the interest rates on their bonds declined. The German 10-year bond dropped below 50 basis points. Then, the European Central Bank announced a large QE program designed to keep bond yields down. So, if you were a global investor, would you prefer to receive less than 50 basis points for 10 years, or close to 200 by buying a U.S. Treasury bond? Everyone wants more, which is why money is coming into the United States. This strengthens the dollar.
Is there a currency war going on?
We don’t think so. We think the dollar’s strength is a reflection of where we are in our economic recovery as compared with countries around the world.
How will the strong dollar affect earnings
for U.S. multinationals and indices such as the S&P 500 index,
and how has U.S. Trust adjusted its forecasts
to account for the effect?
As the dollar strengthens, it takes more units of foreign currency to buy one U.S. dollar, so the more earnings a company has overseas, the more the earnings are negatively affected when the currency is translated back into U.S. earnings reports. Of course, companies don’t bring back all their foreign earnings each quarter, so much of this effect is on paper. And they employ strategies such as hedging currencies and raising prices of goods and services in countries where the currency has depreciated.
Some sectors are more affected by the currency translation than others, such as energy and technology, which have the largest overseas earnings and the most exposure. Overall, we reduced our earnings expectations for the S&P 500 this year by less than 3% but kept our 2,200 target for the S&P 500, as we expect multiple expansions in line with the improving economy. There is a strong positive correlation between the strengthening dollar and multiple expansions. The dollar is strengthening because the U.S. economy is growing more than others, so naturally investors are willing to pay more for that growth. It is very similar to the 1990s, which were strong for the economy, for earnings and for the stock market despite the strengthening dollar.
Where should investors allocate their assets
given the strong dollar?
Consider adding hedged exposure when buying international equities and bonds.
We think the dollar’s strength is a reflection of where we are in our recovery as compared with countries around the world.
But don’t ignore nonhedged exposure, as there is demand for global equities as the global economy continues to grow. These companies stand to benefit from the easing moves we discussed, low inflation, the benefits of lower prices for oil and commodities, and weaker foreign currencies as foreign companies’ products and services become more competitive.
Will the strong dollar make the United States
It makes our goods more expensive overseas so it hurts exports and growth. But it is important to keep this in context. Exports account for only 13% of our economic output. And we have many other advantages that make us very competitive, such as low oil and energy costs, a highly productive workforce and incredible technology.
How does it affect inflation in the United States?
The strong dollar will reduce inflation, as foreign goods and services imported to the United States will be cheaper. Also, since oil is priced in U.S. dollars, as the dollar strengthens, it tends to reduce the price of oil since foreign buyers find it more expensive and demand is reduced. This reduces inflation here in the United States.
Is the Federal Reserve taking all of this into consideration?
Yes. As they raise rates, this could lead to more capital seeking our higher returns, which would strengthen the dollar even more, causing reduced growth. It’s a negative loop. The Fed has acknowledged this risk. It could lead them to raise rates over a longer period of time than they have in the past in order to assess the impact over a larger span of time, in an attempt to push out any future recession.
What happens if the dollar strengthens too much?
If it strengthens too much, say by another 20%, we could see reductions in earnings estimates for U.S.-based companies, a negative effect to our export growth, and some risks in emerging markets countries and companies that might have issued U.S. dollar–based loans and would have to pay them back with much weaker currencies. Given its current value, we think the big move in the dollar is done, but we continue to expect the dollar to strengthen versus its major trading partners over the near to medium term.
Image of Weights: Scott Tysick/Getty Images
Investing involves risk. There is always the potential of losing money when you invest in securities.
Projections made may not come to pass due to market conditions and fluctuations. Past performance is no guarantee of future results.
Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.
OTHER IMPORTANT INFORMATION
Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.
Fixed Income Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa.
Treasury bills are less volatile than longer-term fixed-income securities and are guaranteed as to timely payment of principal and interest by the U.S. government.
International Investing International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.
Other The Standard & Poor’s (S&P) 500 index tracks the performance of 500 widely held, large capitalization U.S. stocks.