Several unexpected events have happened since the election of Donald Trump as President. Among the most surprising for investors has been the fact that the dollar has become significantly stronger. Below is a chart of the US Dollar Index, a trade-weighted index that consists mostly of the euro and yen given the importance of trade completed in these two currencies. The Chinese renminbi is not represented in the index, which dates back to 1973 when China was not a significant player in the global economy. Some investors might consider this to be a weakness of the index, but no index is perfect and the Chinese currency is not freely traded against the dollar. There are valid reasons to look at the dollar index despite its weaknesses.
In the chart above, we can see the dollar has gained more than 5% since the election, a relatively large move in the currency markets. Some analysts have searched for a reason to explain the move. There is speculation that Trump’s economic policies could spark faster growth or the Federal Reserve’s low interest rates might be goosing growth after eight years. As investors, it’s not important to understand the cause of the price move, it is only important to consider what the move might mean to our portfolios. This can also be seen in the headlines of financial web sites. The rapid gain has left many investors wondering how the currency move will affect the stock market. The answer is that there is no way to know the answer.
The truth is there is no reliable relationship between the dollar and the stock market. There are, however, some important points to consider based on history.
Another truth about the dollar is that large price moves invariably bring out prophets of doom. We are always being warned that the dollar is too high or too low and this will affect the global economy and the stock market.
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Recent strength in the dollar has led some doomsayers to warn of a crash in the stock market. They argue a strong dollar hurts sales of large companies who do business around the world. This is logical based on the fact that currencies trade in a “zero sum game” with a loss in one currency required to offset gains in another currency.
When the dollar is strong, the currencies used in other countries weaken. This makes imports by those countries more expensive. An illustration of this argument could be that when the dollar is strong, Saudi Arabia will not be able to afford to afford to buy as many airplanes from Boeing as they would if the dollar were weak. This argument seems to assume the size of the global economy is fixed and ignores the dynamic relationships that drive economic growth. It is entirely possible for all countries to grow even as currencies move up and down. Growth could create more units of currency.
Another way to look at this situation is that the stronger dollar reflects an increased demand for money because the world’s economy is growing more than expected. While there are changes in the relative values of different currencies, there is more currency when the economy grows. Under this view, a growing US economy leads to gains in the dollar and economic growth requires more energy resulting in Saudi Arabia selling more oil which helps its economy grow. That means Saudi Arabia has more money to spend on airplanes from Boeing and this scenario, repeated across thousands of companies and hundreds of countries, is bullish for stocks.
There is some evidence for this argument, shown in the next chart, which shows that stocks can go up along with the dollar as they did during the bull market of the late 1990s many investors wish would repeat. Stocks delivered double-digit gains over this time, even as the dollar rose.
Bears will always find fault with any chart. In this case, the bears might point out that the bull market ended with a selloff of more than 50% in the S&P 500 after stocks topped in 2000. Bulls can counter that the index gained more than 270% in the six years before that crash. Of course, the point of the chart is that the dollar and stocks can both go up at the same time and that relationship can hold for years.
Another concern for the stock market bears is that the rising dollar will lead to foreign investors liquidating dollar-denominated assets to meet other financial obligations. In particular, they worry that foreign investors will sell Treasury bonds to raise dollars that can be used to fund international trade. The logic appears to be sound, but again, history tells us this might not happen. The chart below shows US Treasuries in the late 1990s and shows they too increased in value as the dollar rose.
These charts demonstrate intermarket relationships do not always follow logic. In the late 1990s, stock market investors enjoyed one of the strongest bull market in history as the dollar rose and foreign investors seemed to hold onto dollar-denominated assets.
Despite the evidence seen in the charts, bears are arguing that large companies rely on international sales for a large part of their revenue. Although international sales are important, investors may be surprised that they represent less than a third of the revenue of the companies in the S&P 500.
While 31% of revenue is significant, it is only one side of the financial equation. A strong dollar does make imports more expensive for countries like Canada which could decrease sales for some companies but the strong dollar also makes it less expensive for US companies to import products from Canada. The same is true for imports from any country when the dollar is rising. Less expensive imports will reduce costs for many companies and help offset any decline in earnings resulting from lost sales. The exact impact on any company will depend on how these two factors offset each other. Some sectors may be hurt more than others.
The next chart could help identify sectors to be concerned about. International revenue is shown as the light blue segment of each bar. Telecommunications companies have little exposure to foreign markets, just 3% as a sector. Information technology companies have the most exposure to foreign markets with 59% of revenue coming from outside the US.
The bottom line is that a strong dollar does not mean US stocks will necessarily move up or down. As always, the long-term trend will be determined by earnings. The long term, in this case, is considered to be six to twelve months. According to analysts with FactSet, for all of 2017, analysts are projecting earnings growth of 11.5% and revenue growth of 5.9%. For now, the trend in earnings appears to be up and we should expect stock prices to reflect that trend.
But, there is no reason for complacency. Investors should consider being quick to sell in this environment. Many companies break out their exposure to foreign markets in their annual reports. If a company generates most of their revenue overseas, it could be time to sell the company at the first sign of trouble. That sign could be a bearish pattern formation on a stock chart, a downward break of a long-term trendline or a series of downward revisions in earnings forecasts. These signs should never be ignored, especially if macroeconomic factors like a rising dollar threaten the company’s revenue and earnings.