The US Dollar Cools Off

As stocks’ frustrating and disappointing 2022 winds down, we think it is worth noting that a few of this year’s market-related worries may be starting to fade. Globally, oil and gas prices are down—as we write, they have fallen about -40% from their high in USD this year.^[i] Inflation rates in the US and eurozone are moderating.^[ii] In the UK, long-term gilt yields are down as of late.^[iii] Also pulling back from extremes: the US dollar, whose year-to-date rise versus a broad currency basket is down from 11.5% in late September to just 5.9%.^[iv] Even the pound, which fell toward parity with the buck in late September, has strengthened lately, cutting the dollar’s 2022 gain against it from 26.0% to 11.1%.^[v] In our view, this movement isn’t inherently good or bad for stocks. But financial commentators we follow have spun a lot of gloom about the strong dollar in recent months, and we think its easing should help quiet what has been another source of sour sentiment.

In our view, the dollar’s rise this year is more a symptom of global stocks’ woes than anything causal. Whilst global stocks haven’t breached -20% this year when measured in GBP, they have done so in the US dollar, making this year’s downturn a bear market from many investors’ vantage point.^[vi] Typically, a bear market is a prolonged downturn of -20% or worse with a fundamental cause. In analysing market history, we have found it is normal for the dollar to strengthen during global bear markets as part of the general flight to quality mentality that can be abundant during market downturns. In our view, the dollar has also benefitted from the US Federal Reserve’s fast rate hikes and the rise in long-term US Treasury yields, as we find money tends to flow to the highest-yielding asset (all else equal).^[vii] So to us, the dollar’s movement this year is nothing extraordinary, with the record high it notched in the process mostly trivia, in our view.^[viii]

However, commentators we follow didn’t portray it this way. Whenever the dollar swings hard in either direction, we see many commentators argue it is a huge influence over the global economy and corporate earnings—usually a negative one. In the US, we see the weak dollar spur chatter about America’s trade deficit and rising import prices, alongside warnings that import-heavy US businesses will be unable to shoulder rising costs. Outside the US, we see commentators portray the weak dollar as a negative for exporters in the UK, Europe and Asia. On the other hand, a strong dollar usually prompts warnings that weak currencies in the UK, Europe and Asia will wreak economic havoc, as commentators have argued throughout this year. When the pound sank below $1.10 this year, hitting its lowest point since the mid-1980s, many commentators we follow warned it would spell disaster for the UK’s economy.^[ix] Meanwhile, in America, many commentators we follow warn the strong dollar will make US businesses’ overseas revenues decline (since sales in foreign currencies will convert to fewer US dollars, requiring businesses to either take a hit on currency conversion or raise prices and withstand the blow of lower sales volumes).^[x] We have heard this claim ad nauseam in the US since the summer. US-orientated S&P 500 earnings might have continued growing, but commentators we follow warned the pain was coming as companies exhausted ways to delay it.^[xi]

We don’t agree with that claim. For one, whilst the strong dollar does impact US multinationals’ revenues, it also affects their import costs. Few companies complete the entire goods production process in one country only. Most import raw materials and components, and some have overseas production facilities—technically that means they import labour. When the dollar strengthens, all of these overseas costs fall in dollar terms, which can offset some—even most, in some cases—of the impact on revenues. Two, most companies use financial instruments to hedge against currency swings. Three, whilst generally accepted accounting principles (GAAP) require US companies to convert all overseas activity to dollars for reporting purposes, our research suggests that often doesn’t mimic real-world behaviour. Much of this money never actually gets converted if companies simply reinvest overseas sales into their overseas operations. Hence, companies will report constant-currency earnings, which use fixed exchange rates, alongside GAAP earnings. These have proven quite resilient this year, giving a clearer look into the core business, in our view.^[xii]

In the long run, we have found stocks are very good at sorting through issues like this and weighing reality. But in the short run, to paraphrase legendary investor Ben Graham, the stock market acts more like a voting machine, registering sentiment. In our view, it is sort of an act first, think later thing. Hence, we think strong dollar worries had more influence over stocks than they deserved, adding to the cocktail of scary-sounding stories we think hit sentiment this year.

So from that standpoint, we guess the dollar’s recent slide off its autumn high can be considered good news. If nothing else, it may stop commentators from extrapolating further dollar strength—and ease all the earnings gloom that came with it—for the time being. We think it could help alleviate the weak currency worries in the UK and Europe, too. Perhaps that gives commentators we follow one less perceived negative to dwell on. Mind you, we don’t think a weaker US dollar is necessary for stocks to recover. If the dollar stayed strong and US corporate earnings continued holding up ok, we suspect reality beating expectations would probably be plenty bullish. But the dollar’s weakening is also a form of reality proving not as bad as imagined, even if we think the underlying logic is twisted, as stocks tend not to scrutinise such things amidst dour sentiment, in our view. In a year where we think sentiment has been the predominant force weighing on stocks, we think investors are likely to welcome any relief, whatever the cause.