Corporate profits

The strong dollar is a risk to corporate earnings


The strong dollar remains a risk to corporate earnings and asset prices as the impact on global economies grows.

While many commentators have argued that the dollar will go bankrupt due to excessive debt levels in the United States, such was hardly the case. In 2022, when the American economy is the “the cleanest shirt in the dirty laundry” the dollar rose sharply.

With yields approaching 4% on short-term Treasury bonds, stronger economic growth than most, and stable markets, foreign reserves flowed into the safety and liquidity of the US dollar.

The chart shows the rally in the US dollar and the net trader’s long position in the dollar.

Strong dollar, strong dollar is a risk to corporate earnings

Of course, other currencies must fall if the US dollar recovers. This is because we measure currencies against each other or against a basket of currencies. Like Michael Lebowitz noted in a previous post:

The euro has lost 12% against the US dollar this year, while the Japanese yen has fallen almost 20%. These losses may not seem unusual compared to stocks or bonds, but they are. Foreign exchange markets tend to be much less volatile.

A weak currency against the dollar is often good for a country because it makes its exports more competitive. However, a weaker currency makes imports more expensive. Given soaring inflation rates, especially energy prices, this example of a stronger dollar is playing havoc in Europe and Japan.

Worse still, many foreign borrowers borrow in dollars. If they don’t hedge currency risk, as many don’t, a strong dollar leads to higher interest and principal payments. They simply have to acquire more expensive dollars to pay interest and principal. As such, a strong dollar is a de facto tightening of global monetary policy.

The chart below shows the strong negative correlation between UST 10-year yields and the Euro and Yen.

Strong dollar, strong dollar is a risk to corporate earnings

As we will see, the problem is that a strong dollar (although in theory good for the country of origin) can become problematic in a globally interconnected market.

Why is a strong dollar problematic?

As we wrote in “Returns are not sustainable” the stock market remains linked to the economy. Witness it:

“Over time, there is a close relationship between the economy, earnings and asset prices. For example, the chart below compares the three from 1947 to 2021.

Since 1947, earnings per share have increased by 7.72%, while the economy has grown by 6.35% per year. This close relationship between growth rates makes sense given the important role consumer spending plays in the GDP equation.

The slight difference is due to periods when profits may grow faster than the economy as it emerges from recession. However, as nominal share prices have averaged 9.35% (including dividends), returns to real economic growth are eventually occurring. It’s because corporate profits are a function of consumer spending, business investment, imports and exports.

Strong dollar, strong dollar is a risk to corporate earnings

Since business income comes from economic activity, slower economic growth reduces that income. In the United States, the Fed raises interest rates to slow economic demand by increasing the cost of borrowed capital. These actions specifically target demand to bring down historically high rates of inflation, which, according to to a recent Gallup investigation, are becoming problematic.

“In August, the majority of American adults now say that price hikes are causing financial hardship for their household.

These Fed actions will, by default, slow US corporate revenue growth. However, the dollar poses another significant challenge to investors.

In the Eurozone and elsewhere, households are under severe pressure from rising food and housing prices and soaring energy prices. This is due to the Eurozone’s dependence on Russian oil and gas supplies, which remain cut off either directly by Russia or through bans on Russian imports. The strength of the US dollar is further exacerbating the problems in the Eurozone, with all commodities trading globally in US dollars. This means that rising energy costs are even more costly based on the exchange rate.

However, it’s not just commodity costs that are rising, it’s everything global consumers are buying from US manufacturers. As noted, 40% of revenues for S&P 500 companies come from international sales. Therefore, as the dollar strengthens, these products become too expensive for global consumers.

Strong dollar, strong dollar is a risk to corporate earnings

Therefore, as demand weakens domestically and globally, investors should not expect corporate earnings to remain near record highs. As noted, the current gap between asset prices and corporate earnings is at its widest on record.

Strong dollar, strong dollar is a risk to corporate earnings
Strong dollar, strong dollar is a risk to corporate earnings

Dollar strength will undermine the Fed

As noted, the Fed is currently raising interest rates and shrinking its balance sheet to stifle economic activity and ease inflationary pressures. In “market language” that’s what we call “monetary policy tightening”. In a vacuum, Fed rate hikes will work as expected and could lead to a controllable economic decline. However, the Fed’s policy tools are blunt instruments and are subject to the impacts of other catalysts such as a strong dollar, higher borrowing costs and inflationary pressures. As noted, while the Fed attempts to tighten monetary policy, the economic environment has already tightened policy significantly.

Strong dollar, strong dollar is a risk to corporate earnings

The stock market’s current detachment from underlying profitability is already guaranteeing poor future outcomes for investors.

Profit margins are probably the most mean-reverting series in finance, and if profit margins are not mean-reverting, then something has gone wrong with capitalism. If high profits don’t attract competition, there’s something wrong with the system and it’s not working properly. – Jeremy Grantham

Strong dollar, strong dollar is a risk to corporate earnings

But the strong dollar will most likely exacerbate the problem for investors and the Federal Reserve.

As investors cling to the “hope” that the Fed has everything under control, there is more than a reasonable chance that it is not.

Either way, there is one truth about stocks and the economy.

“Stocks are NOT the economy. But the economy is a reflection of what is supporting rising asset prices: corporate profits.

The strong dollar may be the “pin” which eventually pricks the asset bubble.

Original post

Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.