The Strong Dollar Fans Fears Worldwide

The S&P 500 charted a new closing low after falling -4.0% in price terms on Wednesday, extending earlier declines across Europe.^[i] Much of the downturn appeared to be sympathy selling as two large American retailers announced high costs are pressuring their earnings, but that wasn’t the only negative story making the rounds. The strong dollar remained top of mind, with pundits warning of the danger it poses to economies overseas, including its contribution to the UK’s big April inflation jump. While we think some of these warnings are fair to a degree, others seem quite overstated. More broadly, though, we don’t think currency strength or weakness has a set impact on a given country’s returns.

Why Is the Dollar Up?

Most dollar observers blame “divergent monetary policy” for the dollar’s ascension, implying the Fed’s rate hike plans represent a unique tightening trajectory. Which seems like a mixed conclusion based on the evidence. The Bank of England (BoE) has actually tightened more aggressively thus far and has signaled similar plans as the Fed. The European Central Bank (ECB) hasn’t yet started raising rates, but it is tapering its asset purchases and has jawboned about hiking later this year. Canada and Australia have also started hiking. The only true developed world outlier is the Bank of Japan (BoJ), which is sticking with negative rates and pegging the 10-year Japanese Government Bond (JGB) yield to a ceiling of 0.25% and buying “unlimited” quantities of JGBs to do so.

But in our view, the movement is less about the expected direction of tightening and more about the simple truth that, all else equal, money flows to the highest-yielding asset. The dollar wins that honor, as the 2.88% 10-year US Treasury yield trails only Australia, Canada and Italy among developed nations—and those three countries aren’t big enough to sop up demand for high-quality bonds.^[ii] Adding to that demand is the dollar’s long history of being the world’s preferred safe haven during times when fears run high. At such times, people tend to flock to securities they view as sources of stability, and Uncle Sam’s full faith and credit—plus US capital markets’ unmatched depth and liquidity—make the greenback the top choice. Today, global stocks are flirting with a -20% decline from early January’s high (the technical bear market threshold, although sentiment seems like the downturn’s chief driver, and we don’t see much practical difference between -19% and -21%). They are also dealing with a cacophony of worries. It doesn’t shock us that the combination of a deep pullback and abject fear would drive a flight to quality mentality. That perhaps also points to the dollar slipping back as sentiment improves.

The Developed World Perspective

In Europe, strong dollar fears center on inflation. One thesis making the rounds in Britain right now is that the pound’s sharp decline this year represents global investors losing faith in the UK economy and the BoE’s credibility, while also contributing to higher inflation—creating a vicious circle of a weakening pound and accelerating inflation and carrying a big economic toll. That thesis ignores the fact that other global currencies are also down big versus the dollar—some even more so—but that reality isn’t lost on the eurozone and Japan, where worries about importing inflation also reign.

A weak currency does add to inflation. For example, in the UK, when the pound is weak, if exporting nations with stronger currencies don’t cut their prices, then imports cost more—it takes more sterling to buy goods denominated in those currencies. Same goes for eurozone nations and Japan when the euro and yen are down. But the impact is greater in some countries than others, as it depends on which goods—and how much—a country imports. Japan is smarting right now because it relies on imported energy, and energy is priced in dollars. So Japan—where the yen is down near ¥130 per dollar—must pay high oil costs plus the extra yen necessary to compensate for currency translation. This is a big reason why Japan’s producer price index (PPI) just jumped 10% y/y in April, the first double-digit rise since data begin in 1981.

But for the UK, the pressure from the weak pound should be less acute. It produces much of its own energy, and despite running a chronic trade deficit, imports of goods represented less than one-fourth of the country’s total national expenditure last year. US imports were a small subset of that, just 8.2%.^[iii] Meanwhile, the EU generates almost half of the UK’s imports, and the pound is basically flat relative to the euro this year. Its other major non-EU trading partner, China, generated 13.3% of imports—and the pound is down just slightly relative to the renminbi this year.^[iv] The main contributor to ongoing inflation—which accelerated to 9.0% in April, generating feverish headlines Wednesday—are high energy costs and the April reset of the household energy price cap. That is the difference between now and 2016, when UK CPI rose just 0.7% over the full year despite the pound weakening near its present level versus the dollar.^[v] (Note also that CPI accelerated to 2.7% in 2017 even as the pound strengthened.^[vi])

As for the eurozone, the impact is mixed. It does import a lot of energy, as the fallout from Russian sanctions has reminded the world, but the bloc broadly isn’t as import-reliant as Japan. Then too, much of the eurozone’s trade is among member-states, where currencies aren’t an issue. Over the trailing 12 months through March, imports from the US have averaged 9.2% of total eurozone imports.^[vii]

A strong dollar does create some headwinds for European and Japanese companies that import parts and labor from the US, but most of these companies also export finished products, which is where their weak home currencies become more of a benefit. If they don’t choose to cut prices here in an effort to gain market share, they can boost profits by pocketing the extra gains from currency conversion, which many Japanese firms did when the yen weakened in 2013. The effect of higher import costs and higher export profits may not perfectly offset, but it—plus currency hedging—tends to help limit the impact on corporate earnings. That won’t stop companies from blaming any weakness on currency, as it is an easy scapegoat, but the math usually works out ok.

The Emerging Markets Perspective

Emerging Markets (EM) nations also attract concerns about the strong dollar raising import costs, pressuring businesses’ margins and—in energy-importing nations—households’ energy costs. But debt is arguably an even greater concern, as many EM nations issue bonds in US dollars. When their currencies weaken, interest and principal payments become more expensive, making debt harder to service. The combination of this and unstable currency pegs drove 1997’s Asian Currency Crisis, which saw South Korea, Thailand and Indonesia take IMF bailouts. Malaysia and the Philippines came close. Since then, every whiff of a strong dollar has sparked fears of a repeat.

We think this is a stretch for a simple reason: The chief issue in the late 1990s wasn’t debt financing, but the currency pegs. Throughout the 1990s, Emerging Asian countries had used their pegs to secure dollar-denominated financing at favorable interest rates, and that underpinned much of their economies and financial systems. When the dollar began strengthening against most global currencies, these nations had to spend down their foreign exchange reserves in order to maintain the pegs. As regularly happens, it didn’t work and they were forced to ditch the pegs. Thus it was the one-two punch from spending down reserves to defend a peg, then then shock of discarding it, that caused calamity.

That isn’t a factor today. All of these countries have free-floating currencies—there is no devaluation shock-and-awe factor. The exceptions in the region are Hong Kong, which is a developed market, and China, where monetary authorities let the renminbi trade within a tight band relative to the dollar. Until April, it looked like they were putting a defacto floor under it, as the renminbi traded suspiciously flattish. But that caused China to import a strong currency relative to the vast majority of its other trading partners, and officials there are also looking to boost growth after the latest COVID lockdowns end. It seems they determined that letting the renminbi weaken in order to give exporters a boost from currency translation was an easy way to do that, as it has slid from under ¥6.40 per dollar in early April to nearly ¥6.80 now.^[viii] Oddly, this is a much larger move than the “shock” devaluation that roiled global markets in 2015, yet commentators seem barely to have noticed, suggesting to us that the renminbi’s power over sentiment is spent.

In our view, the resurrection of Asian Currency Crisis fears is emblematic of where sentiment is. People are looking for the proverbial monster around every corner. That mentality is a hallmark of late-stage downturns, which we think is a strong indication we are likely closer to the end of stocks’ ongoing negativity than the start of it.