The Surging US Dollar

Earnings estimates are coming down. In fact, the aggregate earnings estimate for the S&P 500 has dropped roughly 10% since late 2014. According to data from the Standard & Poor’s web site, S&P 500 operating earnings are now expected to grow just 5% compared to the estimate for 2014. If the current trend of downward revisions continues, there may be no earnings growth at all this year when it’s all said and done. Negative revisions to earnings expectations are not typical of an economy that is gaining strength. So what is going on?

There are several factors weighing on earnings expectations, and therefore stock prices. One factor that is gaining increased attention is the dramatic rise in the value of the dollar. The US Dollar Index (DXY), which measures the value of the dollar against a basket of major world currencies, is currently hovering at a 12-year high after appreciating around 23% since mid-2014. The implications of a sharply higher dollar are many. So let’s dig into this further and see if we can’t clarify what’s going on.

The most obvious problem with a soaring dollar is that US companies that generate revenue outside the US are at a competitive disadvantage compared to their foreign competitors. The implicit assumptions here are that 1) US multinationals do not have effective currency hedging programs, and 2) the expenses at these multinationals are incurred in US dollars. If either of these is untrue, specific companies may have reduced at least some of their currency exposure. In any event, compounding the problem for multinationals is the fact that earnings will take a hit as they are translated back into US dollars in each reporting period. Estimates vary widely, but given that at least 30% (and perhaps well over 40%) of S&P 500 revenue is derived outside the US, the dollar’s strength is having a big effect on profitability for the index at large.

A second effect from a higher dollar is that commodities, which are largely traded in US dollars, are falling in price. We have already seen the fallout that plunging oil prices are having on the Energy sector, which now represents just 8% of the total S&P 500 index. According to data from S&P, earnings for S&P 500 Energy companies are set to fall over 50% in 2015 as a result of the drop in black gold. And while a surge in supply is responsible for much of the big decrease in oil prices, tepid demand and the stronger dollar are also certainly factors as well. The dollar’s strength also translates to weakness in other commodity prices, putting earnings in the Materials sector, for example, at risk of further negative revisions.

aa55f4ca-c430-475c-b424-0b265213a090Source: Bloomberg

A rapidly rising dollar also creates significant systemic risks in the capital markets. The Fed’s aggressive monetary policy created “easy money” by pushing down interest rates to very low levels. Higher-risk issuers in emerging markets and within the Energy sector found the interest rates too attractive to ignore. Now that the Fed is set to raise rates and the dollar is rising, those same bond issuers may find themselves in trouble. Issuers in emerging markets who generate revenues in their own currencies will find it much harder to repay the dollar-denominated debt. In addition, capital flight out of emerging economies and into the US could cause rapid increases in interest rates for emerging market issuers. Issuers in the Energy sector, particularly the smaller and less creditworthy companies, will struggle to repay huge amounts of debt issued before the dollar surged and oil prices plummeted. At some point, these pressures could be felt throughout the global economy. The Fed’s aggressive monetary easing has forced investors in risky assets. The unwinding of this process is unlikely to go smoothly.

A higher dollar also has implications for US economic growth. Exports add to domestic GDP, while imports subtract. As the dollar falls, imports become cheaper relative to domestically produced goods and services. In 2014, an increase in the trade deficit subtracted 23 basis points from GDP growth. Most believe that figure will go much higher in 2015. Moreover, the rapid growth in imports associated with the dollar strength results in the US effectively “importing deflation” at a time when the Fed is trying to generate more inflation. In other words, the strong dollar is complicating matters for the Fed.

Where is much of the recent earnings growth coming from? Corporate buybacks. According to a March 4 article in The Wall Street Journal, “In the six full years following and including the financial-crisis nadir – so, 2009 through 2014 – a net of $41.2 billion has gone into equity funds, according to data from Lipper Funds. Meanwhile, in the first three quarters of 2014 alone, corporate buybacks rose 27%, to $567.2 billion.” This is a stunning statistic. The article goes on to say that “buyback authorizations in February, at $118.32 billion, were the strongest for any February on record, according to data from Birinyi Associates.” Should investors pay up for earnings growth generated through buybacks? So far they have, but this game of financial engineering is likely to lose its luster if for no other reason than stocks are no longer cheap. All else equal, buybacks are set to be meaningfully less accretive when executed at dramatically higher prices.

We’ve argued that earnings quality is a factor that has been underappreciated by investors during the course of this bull market. Corporate profit growth has benefited from several unsustainable factors, and margins that are running some 50% above long-term averages. We have also argued that there cannot be a complete “decoupling” between the US and the rest of the world. It appears as though the market is beginning to catch on to these notions. We continue to believe it makes most sense to own high-quality, conservative large-cap companies with fortress balance sheets and superior management teams. There is no wisdom in crawling onto the thinner branches if a storm is coming!