Dollar strength may fuel equity volatility

Dollar strength may fuel equity volatility

Most investors’ failure to properly factor in the dollar’s role in US company earnings could mean they will be exposed to ramped-up equity volatility, Franklin Templeton’s Toby Hayes has said.

The multi-asset manager said the US currency’s impact on the level of earnings made by American companies could be enough to increase volatility “at best” or lay the groundwork for a “possible correction”.

Mr Hayes said the past weakness of the dollar had been a strong contributor to the favourable earnings posted by the largest US businesses, which the manager said were predominantly multinational operations.

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The prior weakness of the greenback meant when the foreign earnings of these firms were converted, a significant boost was given to earnings.

But the appreciable rise in the dollar in the past year will mean those overseas earnings do not provide such a strong tailwind.

“Most of the stocks in [the S&P 500] are multinational companies with earnings stemming from outside the United States,” he said.

“When the dollar was weak, those earnings were boosted when overseas profits were converted back into dollars.

“In the face of growing dollar strength, that situation has gone completely into reverse.

“In many cases, earnings forecasts have been cut, which poses the question: [does] the market consider this new development to be a dollar-translation issue or will it reconsider the S&P 500 as an asset class?

“It’s a benchmark asset class, so purely looking at the dollar, you could argue strongly that the equity volatility is at best likely to rise and is potentially set up for a possible correction.”

To add to the mix, Mr Hayes said in light of an interest rate rise being ever more likely, he claimed to be witnessing “a possible structural rise in volatility, certainly in US equities”.

The manager said another so-called “macro hurricane” was the apparent slowdown in the rate of China’s GDP growth, which he suggested had put pressure on commodity prices.

“It is significant that the effect of both a strengthening dollar and falling commodity prices might be expected to be felt particularly keenly in emerging market economies,” he said.

“For example, emerging markets that produce commodities have seen national incomes fall in many cases.

“On the other hand, some countries, such as India and others in Asia that are net importers, have had a massive bonus from the commodity price declines.

“Still, we fear a number of emerging market economies may have overleveraged. For those that bought in dollars, we think any continuation of the growth in dollar strength will likely put the squeeze on them.”

Mr Hayes added it had been “no coincidence” that previous periods of dollar strength had occurred alongside currency crises in some emerging markets.