Opinion  

Strong buck will pass

Nandini Ramakrishnan

As the US third quarter earnings reporting season hits the halfway mark, investors will be asking whether this quarter will be different from the last. The answer is, probably not – at least at the broad index level. We should expect to hear the same stories this summer as we heard back in the Spring: the high US dollar and lower oil prices are hurting US companies. But this does not mean there is not value in the asset class and that future earnings will stay soft.

The sharp surge in the dollar has had three broad consequences in the US: on the economy, on corporate earnings and on investor returns. The dollar’s appreciation in 2014 was swift, taking it to levels not seen since 2003. It is possible that the dollar will appreciate again once the US Federal Reserve has actually raised interest rates, but we believe that it would be overvalued at that point. What is more, the rate rise is hardly likely to surprise market participants, and should largely be priced in already. At the very least, we would expect any further appreciation of the dollar over the next six to 12 months to be much more gradual than the rally that has already occurred.

While the stronger dollar has been a drag on the US economy, it has been a boon for Europe. This negative effect occurs primarily through the export sector. Gross exports of goods and services constituted 13 per cent of US gross domestic product in 2014, and the stronger dollar reduces demand for US-made goods and services as foreign ones become relatively more attractively priced for foreign consumers and corporations. While there should also be compensating positive effects from stronger US consumer purchasing power, this effect is slower to materialise.

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According to Standard & Poor’s estimates, approximately 46 per cent of sales for S&P 500 companies come from international sources. Corporate earnings are not only affected by lower international demand but through the foreign currency translation on financial statements. Specifically, US multinationals experience smaller sales gains on their income statements for the same amount of international sales when the US dollar is strengthening. This directly affects their top and bottom lines.

Currency moves are often a scapegoat for poor earnings results, but it is undeniable that the US dollar has recently been a significant negative for many big US companies. This, along with lower oil prices, resulted in a poor fourth-quarter 2014 earnings season, which saw earnings shrink by 5.3 per cent on a year-on-year basis. The first-quarter 2015 season saw a year-on-year earnings decline by 5.5 per cent for identical reasons. Current bottom-up analyst estimates suggest that the second-quarter earnings season will see yet another decline before earnings stabilise and recover in the third and fourth quarters. This is due primarily to an expected stabilisation in the dollar and oil prices.

It is difficult to precisely quantify the impact of a rising US dollar on corporate earnings. However, we can get a sense of the magnitude by identifying companies that are more sensitive to currency movements and comparing them to those that are more domestically focused. This can be done by calculating the proportion of each stock’s historical variation in returns that is explained by variation in the dollar. Intuitively, if the variation in a stock’s return over time is largely explained by dollar movements, then it is more likely to be a multinational company with a significant portion of international sales, or a company whose prices are dollar-sensitive. We can then rank stocks according to this dollar-sensitivity and split the index into ‘exporters’(40 per cent of the S&P 500 with the highest sensitivity to the dollar) and ‘domestic companies’ (the remaining 60 per cent of the S&P 500. The dollar’s effect is clear: first-quarter 2015 earnings-per-share (EPS) growth for domestic companies was 12.0 per cent, whereas exporters’ EPS only grew 1.0 per cent year-on-year.