The curious case of dollar strength

By Russ Koesterich, BlackRock’s Global Chief Investment Strategist

US stocks decline as the dollar impacts earnings

US equities finished in the red last week. The Dow Jones Industrial Average fell 1.79% to 17,373, the S&P 500 Index slipped 1.28% to 2,077 and the tech-heavy Nasdaq Composite Index dropped 1.66% to close the week at 5,043. Meanwhile, the yield on the 10-year Treasury fell from 2.20% to 2.17%, as its price correspondingly rose.

Large US companies continue to struggle with the competitive headwind caused by a stronger dollar. Curiously though, small caps, which have lower exposure to international sales, are not benefiting.

On the bond side, US economic data remain mixed, but strong enough for investors increasingly to assume the Federal Reserve (Fed) will raise interest rates this fall. Those expectations are leading to what’s known as a flattening of the yield curve, whereby shorter-term bond yields rise faster than yields on longer-term bonds, as the former sell off. Accordingly, we continue to believe long-term yields will remain contained, but shorter-term bonds remain vulnerable.

No solace in small caps

In the US, earnings season has been better than expected, but lower estimates of third quarter earnings are keeping a lid on any gains in stocks. Equities were also hurt by several companies, including Disney and Sears, failing to meet earnings expectations. So far this year, the S&P 500 Index is struggling to hold onto a 1% gain, while the Dow Industrials and Transport indexes are now solidly in negative territory year-to-date.

Overall, however, the second quarter was not the earnings disaster some had expected, but it has failed to inspire investors. Sales were down 4% year-over-year, while earnings grew by 1.5%; excluding energy, that figure jumps to 9.3%. While low rates and sluggish wage growth allowed profit margins to remain at record levels, a strong dollar has hurt companies’ revenues.

Many investors have been favoring small-cap stocks, which depend less on international sales than larger companies, in an effort to mitigate the impact of a stronger dollar. But the strategy has not provided much benefit. The large-cap S&P 500’s modest 1% gain is slightly ahead of the small-cap Russell 2000 year-to-date.

What exactly is holding back small caps? While they do have less exposure to international sales, small cap stocks have proved more vulnerable to rising real interest rates (the interest rate after inflation) and investor anticipation of monetary tightening.

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