Today’s Headlines: Effects of the Strong Dollar

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Today’s Headlines: Effects of the Strong Dollar
April 14, 2015
Strong Dollar: Friend or Foe?

The strength of the American economy compared to the rest of the world has pushed the dollar to new heights relative to other currencies. The US Dollar Index (NYSE:DXY) is near 100, up more than 20% change from a year ago. The dollar has almost caught the value of the Euro, trading around $1.06 per Euro compared to $1.37 a year ago.

For American consumers, this is generally good news. Imports are less expensive, and your dollar buys more when traveling abroad. For corporations, it’s a muddy picture at both micro and macro scales because there are positive and negative effects at each scale.

A Broader Economic View

On the macro scale, the strong dollar is thought to be troublesome because it represents several drags on corporate growth.

Fortune reports that 30% of the US-based S&P 500 firms generate more than 50% of their revenue overseas. These companies face a double-barreled threat of cheaper products by foreign competitors in their home markets and currency conversion losses (sales in foreign currencies shrink during the conversion to dollars). Add in decreased global demand, as the strong dollar reflects weakness in foreign economies, and both earnings and company stock prices are likely to suffer.

History suggests that this effect will slow the broader US economy. According to Time, since 1970, there have been five major drops in corporate profitability, and all five occurred after reduced corporate sales induced by relative strength of the dollar.

Yet the strong dollar does not automatically mean a poor bottom line for US-based multinationals. For example, consider the heavy equipment manufacturer Caterpillar (NYSE:CAT). Despite having over 60% of their sales overseas with a large presence in China, the strong dollar actually helped Caterpillar’s 2014 bottom line, according to VP of Financial Services Mike DeWalt. Their outsourcing takes advantage of cheaper raw materials and manufacturing in facilities outside the US. Consequently, the slowing growth in China is partially offset by lower production costs.

Potential Positives of the Strong Dollar

There are other effects on the positive side of the ledger. While exporters are hurt disproportionately by the strong dollar, especially those whose operations are 100% domestic, exports account for roughly 13% of the US economic output. The hit in exports alone should not be enough to derail the US recovery, although it could certainly slow it

Meanwhile, the dollar’s strength is helping to keep inflation down, supplementing the job that falling oil prices started. This seems to be giving the Federal Reserve continued reason to delay raising interest rates, as neither the economic growth rate nor inflation warrant a rise. As long as this remains so, stocks are going to be the preferred growth investment.

As other central banks continue stimulus programs and currency devaluation, they increase the strength of the dollar in the short term, but they promote transfer of both capital and demand to their own countries in the longer term. Indeed, over the last month US investors have removed $11.5 billion from US mutual funds and transferring $6.7 billion into international funds. In theory, the foreign economies should improve, beginning to bring currencies back into equilibrium and creating greater global demand (including demand for US products).

Winners in the Current Environment

On the micro scale, individual businesses may be affected strongly in either direction depending on their business model, customer base, and their role in the global economy. Large multinationals have ways to hedge and deal with changes that smaller corporations do not.

Winners in this environment are companies like Alcoa, which mines most of their raw materials overseas with currently lower production costs, yet sell the majority of their products into the U.S. domestic market with limited competition. Alcoa maintained strong earnings in Q4 2014 and, while earnings were lower in Q1 2015, they still beat 1st quarter analysts’ estimates.

Companies on the other side of this equation, with mostly domestic production and overseas sales, are likely to suffer as a result.

The Takeaway

Economists cannot agree on the strong dollar’s effect on the economy as a whole. Some predict an overall stimulus effect while others expect a continued drag on economic growth, with earnest and smart people occupying both sides of the debate.

However, trying to predict the broad scale effects doesn’t help you as an investor. It’s best to focus on the micro instead of the macro — focus on the companies in your portfolio. To assess the overall effect of the strong dollar on your investments, it’s important to look at the direct effect on the companies you invest in, whether it’s in direct stock investments or indirectly through mutual or index funds.

Check into the company’s forecasts, and if possible, any announcements related to earnings and forecasts. How much of the company’s operations and sales are overseas vs. domestic? Is their competition primarily foreign or domestic? What is their outlook on jobs and hiring? These questions can help you assess the risk of investing in those companies — in essence, how strongly they are affected by macro scale events and in what direction.

Unless you want to dabble in the currency market — which we don’t recommend unless you are very familiar with the field and quite well funded — you can make the best headway by rebalancing your portfolio based on the risk of a continued strong dollar. It doesn’t seem to be going away anytime soon.

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