No, Dollar Strength Doesn’t Mean Weak Stocks

Market volatility may not be predictable, but the behavioral quirks it spawns usually are. Take, for instance, headlines’ tendency to tout new fears to either explain the dip or argue there is much worse to come. We have seen the latter in recent days, as the dollar has returned to the fore. This time, some pundits argue a stronger dollar will hit US stocks’ earnings—particularly US Tech’s earnings—as overseas sales lose value, storing up trouble for the S&P 500. That may seem plausible enough on the surface, but a quick run through basic economics and market history shows it doesn’t hold true.

Now, we aren’t so sure the dollar will soar from there. Arguments that it will rest on the presumption that Fed rate hikes will drive long-term Treasury yields higher, causing overseas investors to flock to Uncle Sam’s IOUs. Those inbound currency flows, allegedly, will drive the greenback skyward. Problem is, this isn’t how markets work—they look forward, pricing in widely expected events well in advance. Rate hike chatter is widely known, as is America’s elevated inflation rate. If either of these were a material forward-looking driver for long rates, yields would already reflect it. Yet 10-year Treasury yields, while up about a quarter of a percentage point since late December, are basically flat since mid-March 2021.^[i] Arguing pending rate hikes create material upside in long-term yields from here is tantamount to arguing markets aren’t efficient at all. In our experience, that is usually the losing side of the debate. With that said, range-bound long-term rates might still attract overseas capital, but here, too, currency markets are extremely liquid and efficient—and Treasury yields’ premium over their European and Japanese counterparts is also well known and likely priced in. That doesn’t preclude short-term swings, but we think it argues against a sustained move higher.

And if we are wrong? That still doesn’t mean earnings gloom awaits. Yes, all else equal, when the dollar strengthens, if US-based multinationals don’t raise prices overseas, it reduces the value of overseas sales. This is just plain currency math—pounds, euros, yen and all the rest convert to fewer dollars when the buck strengthens. Yet this same currency math also reduces US-based companies’ overseas costs—crucial, given the volume of labor and resources sourced abroad. Very, very few goods are 100% sourced and produced in the US (or any other major country)—especially Tech hardware. The effect may not be perfectly zero-sum for all companies or even in aggregate, but it often means earnings hold up much better than expected. Stocks move not on absolute reality, but on the gap between reality and expectations. While dollar uncertainty might weigh on sentiment in the short term, eventually a positive earnings surprise would likely bring big relief to stocks.

While this concept is a bit abstract, a concrete (and extreme) example is playing out in Turkey, where the lira has plunged to record lows versus the dollar. Thus far, “President” Recep Tayyip Erdogan has tolerated and even encouraged it, arguing the weak lira is responsible for Turkey’s jumping exports. Yet as businesses and farmers will attest, it is also sending costs sky-high. Hazelnut producers are bearing the brunt of it, with prices for seeds, fertilizer and other supplies going parabolic. They are now slashing production, which will slash exports despite the weak lira—bad news for global hazelnut supply, given Turkey generates about 70% of global output.^[ii] For the affected farmers, the weak lira is a curse, not a boon.

Recent S&P 500 returns also seem to disagree a strong dollar is a massive headwind. The dollar spent most of 2019 hovering slightly above today’s allegedly elevated levels versus a broad, trade-weighted currency basket.^[iii] Then, like now, strong dollar fears reigned. Yet the S&P 500 jumped 31.5% that year. From mid-2014 through 2016, as the dollar embarked on one of its steepest, longest climbs in recent memory, the S&P 500 delivered patient investors a 20.5% total return.^[iv]

In our view, the dollar is significant mostly as an indicator of sentiment. Whenever investors get the blues, they find a way to fret the dollar. Sometimes, like now, it is the strong dollar. If the dollar is weak, they fret that too, arguing it will cause the US to import inflation. Whatever the dollar does, if volatility is up and nerves are fraying, it won’t get any love. In our view, the resurgent fears are therefore one more indication that sentiment is deteriorating—we are half a world away from the optimism that reigned a year ago. Eventually, skepticism’s return sets up a tall “wall of worry” for stocks to climb, but don’t be surprised if it brings more wobbles in the near term. Successful investing is about taking the good with the bad, and sometimes that means riding out uncertainty until the fog clears.