The Dollar Cools Off

As stocks’ frustrating and disappointing 2022 winds down, it is worth noting that several of this year’s big fears have started to fade. Oil and gas prices are down, with US average unleaded prices a few cents from pre-2022 levels.^[i] The inflation rate is easing, and forward-looking inflation indicators (e.g., money supply growth, shipping costs, food and commodity prices) point to further relief. Long-term interest rates are down lately, too, and the Fed is jawboning about slowing its rate hikes. 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%.^[ii] In our view, this movement isn’t inherently good or bad for stocks. But headlines have spun a lot of gloom about the strong dollar in recent months, and its easing should help quiet another source of sour sentiment.

We think the dollar’s rise this year is more a symptom of stocks’ woes than anything causal. It is pretty normal for the dollar to strengthen during a bear market as part of the general flight to quality mentality that reigns during downturns. The dollar has also benefited from the Fed’s fast rate hikes and the rise in long-term US Treasury yields, as money tends to flow to the highest-yielding asset (all else equal). So to us, the dollar’s movement this year seems pretty typical, with the record high it notched in the process mostly trivia.

Headlines didn’t portray it this way, however. Whenever the dollar swings hard in either direction, pundits jump on it as a huge influence over the economy and earnings—usually a negative one. A weak dollar spurs chatter about the trade deficit and rising import prices, alongside warnings that import-heavy US businesses will be unable to shoulder rising costs. If you looked abroad over the last few months, you would have seen exactly these fears in Europe, as the pound and euro fell. When it is strong, the dollar prompts warnings that US businesses’ overseas revenues will 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). That is the claim we have heard ad nauseam in America since the summer. S&P 500 earnings might have continued growing, but pundits warned the pain was coming as companies exhausted ways to delay it.

We didn’t—and don’t—buy that claim, as we argued here a couple months back. For one, while the strong dollar does impact US multinationals’ revenues, it also affects their import costs. Few companies produce goods soup-to-nuts in one country only. Most import raw materials and components, and some have overseas production facilities—technically that means they import labor. When the dollar strengthens, all of these overseas costs fall in dollar terms, which can offset some—even most—of the impact on revenues. Two, most companies hedge for currency swings. Three, while generally accepted accounting practices (GAAP) require US companies to convert all overseas activity to dollars for reporting purposes, that often doesn’t mimic real-world behavior. A lot 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 the long run, stocks are very good at sorting through issues like this and weighing reality. But in the short run, as Ben Graham famously said, the stock market acts more like a voting machine, registering sentiment. It is sort of an act first, think later thing. Hence, we think strong dollar fears had more influence over stocks than they deserved, adding to the cocktail of worries hitting sentiment in this bear market.

So from that standpoint, we guess the dollar’s recent slide off its autumn high is good news. If nothing else, it takes the up, up and away narrative—and all the earnings gloom that came with it—off the table for the time being. It should alleviate the weak currency worries overseas, too. That gives pundits one less thing to harp on and investors one less thing to fear. Mind you, we don’t think a weaker dollar is necessary for stocks to recover. If the dollar stayed strong and earnings continued holding up ok, reality beating expectations would probably be plenty bullish. But the dollar’s weakening is also a form of reality proving not as bad as feared, even if we think the underlying logic is twisted, stocks tend not to scrutinize such things when sentiment is in the dumps. In a year where we think sentiment has been the predominant force weighing on stocks, any relief—whatever the cause—is to be welcomed.