Download what the dollar`s surge means to investors

MONTHLY CLIENT LETTER
Investment Management
February 2015
WHAT THE DOLLAR’S SURGE MEANS TO INVESTORS
By Gene Balas, CFA
T
he U.S. Dollar Index surged over 17% since July 1, 2014 in data from the Federal
Reserve Bank of St. Louis. The prospects of a Fed rate hike has attracted investors
to the dollar with the simultaneous prospect that the European Central Bank
would engage in quantitative easing, which would drive down the euro. And indeed, the ECB
followed through on January 22, with its decision to launch a bigger-than-expected bond
purchase program that further fueled the dollar’s ascent, surging 3% against the euro January
22 and 23 alone. So, a simple question is what does this mean for investors? It’s a complicated
issue, touching on a whole host of factors. Let’s discuss each one.
© 2015 United Capital Financial Advisers, LLC. All Rights Reserved
www.unitedcp.com
MONTHLY CLIENT LETTER
Investment Management
February 2015
Corporate Profits
Probably one of the biggest challenges to multinationals is the currency translation of revenues
and earnings from operations abroad, when repatriated into dollars. When the dollar rises,
revenues and profits from abroad are translated into fewer dollars. So, a company can report
higher sales in local terms, but currency translation could swamp that hypothetical gain. And
even if an investor owns a purely “domestic” portfolio of a simple S&P 500 index fund, the
truth is, he or she is very exposed to international economies and may incur this risk.
Standard & Poors breaks down the revenues of the companies in the S&P 500 by geography.
They find that in 2013, 46% of sales came from overseas, with European ex-U.K. sales
representing 5.7% of all S&P 500 sales (that is, when the specific region was identified by
each reporting company; not all companies do). While currency hedging by a corporation can
mitigate some of that risk, it will not eliminate all of it, especially over the longer term, given
the duration of specific hedging contracts. The upshot is that U.S.-based multinationals may
rethink aggressive hiring and capital spending plans globally.
Inflation
A rising dollar, all things equal, drives down U.S. inflation. It does this through several ways.
The simplest is that it makes imported goods cheaper, as a stronger dollar buys more units of
currencies abroad. Imports are 16% of our economy, in data from the Bureau of Economic
Analysis at the Department of Commerce. The second is that it incentivizes U.S. producers
to keep prices lower, to the extent that their products compete against imports. The third is
that, because most commodities are priced in dollars, a rising dollar makes commodities (e.g.,
oil, copper, etc.) more expensive to foreign purchasers. Thus, a rising dollar means falling
prices of inputs into just about every manufactured good, not to mention gasoline and food.
Importantly, lower import costs also mean bigger profit margins of importers.
Trade
A rising dollar makes U.S.-made goods more expensive when purchased abroad, hampering
the competiveness of our goods and services in economies overseas. Exports are 13% of our
GDP, according to data from the BEA. For the Eurozone specifically, our exports of goods
(excluding services) to the Eurozone are just 1.2% of our economy, and our imports of goods
from the Eurozone are 1.9% of our GDP, in data from Census and the BEA. While exports are
a relatively small component of our economy vis-à-vis many other nations, the potential is for
exports to be lower, and imports – which are a subtraction from GDP – to be higher. A bigger
trade deficit would be a drag on our economy.
© 2015 United Capital Financial Advisers, LLC. All Rights Reserved
www.unitedcp.com
MONTHLY CLIENT LETTER
Investment Management
February 2015
Still, many economists believe that this will have a more modest effect on our economic
growth, as the benefits of weaker currencies of our trading partners enables those economies
to eventually post stronger growth, a long-term benefit to our trade figures over time. Healthy
trading partners benefit us in the long run. Still, it can cause some employers – not just those
who export, but those who compete against imports as well – to limit hiring and capital
spending versus what they might do otherwise.
Capital Markets
A stronger dollar makes U.S. investments more attractive to overseas buyers, as it can enhance
their returns when eventually repatriating those assets to their home market. That means that
an influx of foreign capital may boost U.S. stock and bond prices, benefiting U.S. investors
(offset though that may be by potentially slower profit growth in some companies). In tandem,
bond prices would be bid up, driving yields down all across the yield curve, but with a more
pronounced effect for longer maturities. This, in turn, makes the cost of borrowing cheaper
here in the U.S., not just for the federal government and corporations, but for mortgages and
municipal financing needs as well. That can support home prices, as one outcome. A resultant
© 2015 United Capital Financial Advisers, LLC. All Rights Reserved
www.unitedcp.com
MONTHLY CLIENT LETTER
Investment Management
February 2015
wealth effect, in turn, could theoretically boost consumption from those who own appreciating
financial assets or homes. Thus, this is a net positive for the economy.
However, while the rising dollar can benefit U.S. capital markets, it has the opposite effect
when investing internationally. For one, a rising dollar means a subtraction from local currency
returns: It can make gains smaller (or even turn them into losses) and make losses that much
bigger, hurting U.S. investors. The problem is compounded when other investors sell their
local-currency investments to buy dollar-denominated holdings. That capital flight further
depresses asset prices in local currencies, even before currency translation. Not to mention a
capital flight from emerging markets can make it more difficult for those countries to fund
their fiscal balances. It can also increase inflation for certain economies, leading some to
tighten interest rates to stem their currencies’ decline. That move can slow their economies in
the process and drive up their borrowing costs, harming some emerging markets.
But what about instruments that are issued abroad, but denominated in dollars, or those
economies whose currencies are tied to the U.S. dollar? These dollar-denominated bonds or
dollar pegs transfer the risk from the U.S. investor to the entity abroad. A rising dollar makes
it that much more difficult for debtors in emerging markets to repay their dollar-denominated
loans. That can trigger losses if investors question the borrowers’ ability to repay those loans.
And for economies whose currency is pegged to the dollar, a rising dollar means many of
the same things for them that it does for U.S. markets, particularly making their exports less
competitive, potentially disrupting their economy.
Fed Policy
From the items above, we see that a rising dollar can reduce our inflation rates and be a
headwind to economic growth. In a sense, then, a rising dollar acts as a de facto tightening
of Fed policy. That would only compound the effect of an actual lifting of short term rates by
the Fed at some point down the road. However, a rising dollar also can serve to boost asset
prices of U.S. securities, including Treasuries, driving down longer term interest rates, which
is an offset. The net effect is that it complicates Fed policy. Because the Fed wants higher
inflation and full employment at the same time, the rising dollar can subtract from both. The
Fed’s target for inflation is 2%; headline inflation is currently 1.2% in the measure it prefers,
as reported by the BEA. That means that the Fed may be slower to raise rates than it otherwise
might be, perhaps even later than the mid-2015 forecast for a Fed rate hike markets forecast.
Now, here we get to a more arcane matter; namely, net interest margins at banks. Banks profit
by borrowing at (usually lower) short term rates and lending at (usually higher) long term
rates. The difference between the rates at which banks borrow from depositors and what they
lend to borrowers is known as the net interest margin; the bigger this number is, the more
© 2015 United Capital Financial Advisers, LLC. All Rights Reserved
www.unitedcp.com
MONTHLY CLIENT LETTER
Investment Management
February 2015
profitable banks are, everything else equal. When long term rates have fallen by the amount
they have and the yield curve flattens, then banks’ net interest margins shrink.
That makes lending a less profitable endeavor – even as lower borrowing costs encourage
more demand for loans from businesses and consumers. A flatter yield curve could thus be
a drag on the economy if it discourages banks from lending at current rates. Fewer small
business loans could mean a lower rate of entrepreneurship, lowering productivity and the
economy’s potential growth rate both now and in the future. Would the Fed really want
to narrow the net interest margin even further by hiking short term rates? If it did, it could
hamper economic growth far more than if the yield curve was steeper.
Thus, a stronger dollar has a whole host of wide-ranging nuances, from the positive to the
negative. It is hard to say unambiguously whether the results are, on net, positive or negative.
Instead it’s a matter of degrees in a complex interrelation of variables. It certainly complicates
economic models and forecasting, making the Fed’s next move a very difficult one to handicap
accurately.
© 2015 United Capital Financial Advisers, LLC. All Rights Reserved
www.unitedcp.com
MONTHLY CLIENT LETTER
Investment Management
February 2015
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Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements
including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by
their nature, they are subject to known and unknown risks and uncertainties.
© 2015 United Capital Financial Advisers, LLC. All Rights Reserved
www.unitedcp.com