The Strong Dollar Problem

On Tuesday morning we received news that October’s import prices fell year-over-year for the 15th consecutive month. The decline of 10.5% was also the 7th double-digit year-over-year decline year-to-date. With the exception of the financial crisis, we have not experienced import-price declines of this magnitude since the Bureau of Labor Statistics started reporting the data in 1983. The drop in import prices is greeted warmly by struggling middle-class American families who, on average, haven’t seen their inflation-adjusted incomes grow at all over the past couple of decades. However, lower import prices have been a headache for a Federal Reserve that wants to stoke inflation closer to its goal of 2%. So, in this week’s Market Commentary we thought we’d take a stab at not only explaining the sharp drop in import prices, but also describing the interplay between import prices, currency fluctuations, trade balances, and economic growth.

Let’s start with currencies. Since mid-2014, the “trade-weighted” US dollar index has appreciated about 20%. That sounds like a scary term, but the trade-weighted US dollar index is simply the foreign exchange value of the US dollar against the currencies of a large group of major US trading partners. The weightings are based on the how much trading (imports and exports) the US does with the various countries within the index. For instance, if China is our largest trading partner representing 21% of our foreign trade, then the Chinese renminbi will receive a weighting of 21% in the trade-weighted US dollar index.

The value of a currency can fluctuate for a wide variety of reasons that are beyond the scope of this Market Commentary. For the most part, though, the 20% increase in the trade-weighted dollar over the past 15 months can be attributed to: 1) the relative strength of the US economy; 2) the relatively high level of interest rates compared to other developed economies; and 3) the anticipation of Fed interest-rate hikes in the near future. So, in general, capital will flow into countries that can offer superior investment returns. If the US economy is growing more briskly than foreign economies, then it stands to reason that the US will also offer superior investment returns. As capital flows toward those superior investment opportunities in the US, the dollar has spiked in value.

The chart below shows the appreciation in the trade-weighted dollar (gray bars) along with yields on the 2-year and 10-year Treasury notes. You can see that the gains in the dollar preceded the increase in interest rates by a wide margin. Investors were early in both 1) identifying the relative strength of the US economy; and 2) accurately predicting the beginning of Fed policy normalization (which it now appears will be in December). Again, all else equal, money will flow into the countries and currencies that can earn the best returns. These returns can come in any combination of relatively high interest rates, currency appreciation, or appreciation in other financial or hard assets (stocks, real estate, alternatives). In other words, the US remains the best house in a dicey neighborhood, and the strengthening US dollar is simply a reflection of that status.

82bd20a8-7d50-4690-a319-25c78cdccadbSource: Bloomberg and the Federal Reserve

In the next chart, we show the downside of having a relatively strong economy and currency. As noted above, capital will flow into countries with the best prospects for investment returns. As this happens, the home currency appreciates in value, sometimes materially as we have experienced over the past 15 months. When dramatic and rapid dollar appreciation occurs, though, it causes a big impact on the competitiveness of US exports. If I run a US multinational firm and I generate a portion of my revenue in Europe, for example, I’m suddenly faced with accepting payment in a currency that has just depreciated in value (relative to the US dollar) by over 20%. I can raise my prices by 20% to compensate for the lost value, but in doing so I will surely lose market share. Instead, most multinational companies are, for the most part, eating the drop in revenue while making some cost adjustments to limit the damage to profitability. And remember, the Euro isn’t the only currency that has depreciated relative to the dollar. The dollar’s widespread strength is negatively affecting the top and bottom lines of every US multinational, and the evidence resides in disappointing corporate earnings reports and stock market performance in the US.

707bb843-fde2-4be7-8a64-be6b05131bd3Source: Bloomberg and the Federal Reserve

But aside from affecting the profitability of US multinationals, is the dollar strength having a deleterious effect on the broader economy? In theory, it should. Gross Domestic Product (GDP) is the sum of the following: 1) consumer spending; 2) private investment; 3) government spending; and 4) net exports. Exports add to GDP while imports subtract. We’ve already noted that import prices have been dropping for a while now. This should lead to market share gains for foreign importers, and a greater drag on GDP growth. We’ve also talked about how US exporters are suffering mightily due to the appreciation in the US dollar, also creating a drag on GDP growth. So, in theory, imports should be surging while exports should be dropping. And, in fact, this is what the data are telling us. The chart below shows that imports are up about 0.5% as a percentage of GDP since the third quarter of 2014 while exports are down slightly as a percentage of GDP. The net effect is that “net exports” have been a 0.5% drag on GDP growth over the past five quarters. This is not insignificant for an economy that has only been growing 2.0%-2.5% annually over the past six+ years.

d00129ac-7f2b-45a0-9a3c-fad65fdbde1dSource: Bloomberg and the Federal Reserve

In summary, currency changes are the mechanism whereby economies adjust to each other over time. It’s great that a strong US dollar reflects the relative strength of the US economy. But there are downsides to being so far out in front of everyone else. We are, essentially, subsidizing the rest of the world through an appreciating dollar. This isn’t necessarily bad. We need the rest of the world to get healthy because they will be our trading partners long into the future. But to suggest that the US economy is now set to break out on the upside while the rest of the world remains in the doldrums is not realistic. We continue to expect modest 2.0%-2.5% growth for a few more years. Investors should invest accordingly.