Is US dollar strength cause for concern?
Invesco Perpetual’s US Equities fund manager, Simon Clinch, explains the impact of a strengthening US dollar and what it means for US stocks.
- The strong US dollar has the potential to expose the true pricing power of US businesses in foreign markets
- Clinch expects negative impact on demand expectations throughout the next few months
- Currency volatility significantly impairs the ability to accurately model the earnings power of a business
The last six months in US equity markets have been extraordinary, to the extent that we will probably see the word “unprecedented” feature prominently once more in 2014 annual review letters and market outlook pieces for the year ahead. Investors in US stocks have been able to stay inwardly focused for a good year or so, benefiting from the economy’s growth leadership amongst developed nations.
However, the fourth quarter of 2014 saw a sudden explosion of volatility in commodities, currencies and stocks, entirely driven by external factors. Oil prices have fallen by more than 40% from last year’s highs. The VIX Index, a measure of equity market volatility, spiked to levels not seen since the Euro-crisis in the latter half of 2011. And the US dollar rallied hard against virtually every major floating currency. The latter is certainly worth comment.
Since the end of June 2014 to the end of January 2015, the trade-weighted US dollar gained nearly 19%. Breaking this down further, the US dollar gained 21.3% against the Euro; 15.9% against the Yen; 13.5% against the British Pound; 19.3% against the Canadian Dollar; and 26% against the Norwegian Krona. These are big moves for the reserve currency. In fact, if we look at the trade-weight dollar’s year-on-year returns since 1967, the current move represents a 2 standard deviation event matching the moves from 1993, 2000 and 2009. Only the moves in 1981 and 1985 have been more extreme to the upside. The recent move therefore should be considered an important event.
What does this mean for investors in US stocks?
For domestic investors, the impact is twofold: the translation impact on revenues and earnings; and demand implications for the businesses. Foreign investors in US stocks have the added consideration of the impact on portfolio performance in local currency.
The first two factors are headwinds for US stocks. The S&P 500 Index is currently valued at 17. times 2015 earnings estimates, above the average multiple since 1990 and up a significant 4.5 turns since the end of 2011. After more than a year of significant multiple expansion, we believe that further market gains will need to be driven by earnings, and the strength in the US dollar risks dampening earnings growth for the year, particularly if the gains continue.
Translation effects are proving meaningful. Consider at the extreme, Phillip Morris International, a non-US tobacco company listed in the US. With 100% of its business conducted outside the US, and with 30% exposure to the Euro, the rally in the US dollar is already having a very meaningful impact on earnings. According to Bloomberg, consensus 2015 earnings expectations for Phillip Morris International have fallen by around 9% since the beginning of the year, and we can assume that most of this decline is due to currency. Since September 2014, estimates are actually down 19%, and while some of this will have been due to challenging fundamentals, it is safe to say that currency will have played its part in this negative revision trend. Other companies with international exposure are experiencing the same effects with varying magnitudes, but the clear reality is that earnings expectations for 2015 are likely to come down further as management teams provide their financial outlooks during the current reporting season.
The strength of the US dollar also has the potential to impact demand in a number of ways. Many retail companies in the US generate profitable business by selling to tourists visiting the country. The strong dollar clearly impacts the tourists’ purchasing power, and we have already seen some evidence of this. For example, Tiffany’s tourist spending was flat in its flagship New York store during the fourth quarter of 2014.
There are also those businesses that sell products abroad who have one of two choices: to hold local pricing at the expense of margins; or to raise local pricing to protect margins, but this risk impacting demand. In effect, the strong US dollar has the potential to expose the true pricing power of US businesses in foreign markets, and I expect there to be some negative impact on demand expectations as we progress through the next few months