Stocks had another big day Tuesday, but it hasn’t done much to help sentiment as headlines continue stewing over the latest fear: the strong dollar. Some warn it is a negative for the US itself, as a strong dollar hits US-based multinationals’ overseas revenues (never mind that it also reduces their overseas costs and most international earnings don’t get repatriated and converted to dollars). Others focus on international stocks, warning their weak currencies are a headwind and are causing them to import even faster inflation. Add in actual currency market intervention in Japan plus talk of the same in South Korea and China, and currency chaos is top of mind. In our view, this is more a sign of sentiment than an actual negative for stocks, as we will show.
Re-read the prior paragraph carefully, and you may notice a weird inconsistency: the concerns about the US directly contradict the concerns about Europe and Asia. If the strong dollar is supposedly bad for the US, then that implies a weaker dollar would be better. Yet we are also told a weaker currency is a massive headwind in Europe and Asia, implying they would benefit from the stronger currency that is supposedly a massive risk on our shores. Absent some mythical Goldilocks exchange rates, which we have never seen theorized ever, there is no way to make it make sense.
If theoretical arguments aren’t your thing, then consider Exhibit 1. It shows a smattering of major developed and Emerging Markets’ currency moves year to date, along with their year-to-date stock returns in their home currencies and US dollars, their highest inflation rate in 2022 thus far and their most recent inflation reading. As you will see, there isn’t much evidentiary support for today’s prevailing fears. The US, which has the largest currency appreciation, is in a bear market. Brazil, which has the second-best currency of this bunch, has positive year-to-date returns in its home currency. Yet Mexico, whose currency is also up this year, is down double digits in pesos. As for the eurozone’s four largest economies, Germany is down over twice as much as Spain, and the corresponding inflation rates are all over the map. The UK has the second-weakest currency but is down just single-digits, albeit with double-digit inflation. Yet Japan, where the yen is down more than -20% on the dollar, has the second-lowest inflation rate.
Exhibit 1: A World of Currency Moves, Stock Returns and Inflation
Source: FactSet, as of 10/4/2022.[i]
About the only consistency here is the mathematical one: In nations whose currencies have strengthened against the dollar, returns denominated in dollars are a tad higher than in their local currencies, while the opposite is true for nations whose currencies have weakened relative to the greenback. If you are an American investing in overseas companies, you get the company’s return in its home currency plus or minus that currency’s appreciation (or depreciation) relative to the dollar. So, when the dollar strengthens, the overseas company’s return will always be lower in dollars than its home currency. But currency moves are cyclical, and the dollar won’t strengthen this way forever. Eventually, due to changes in interest rates and investor sentiment, it will cool or weaken, at which point returns on overseas stocks will be stronger in dollars as you get the company’s return plus its home currency’s appreciation.
But the rest? The supposed linkages between currencies and returns or currencies and inflation? We don’t think they pass the test. If there was a strong relationship on either front, it would be a powerful forecasting tool, everyone would use it, and there would be no need for this article. In reality, maxims like this are simply “right” just often enough to maintain their reputation but nowhere near often enough to be worth much in trying to figure out where stocks will go looking forward. Said another way, sometimes currencies and returns move in the same direction, and sometimes they don’t. Sometimes currency weakness comes with bad inflation, and sometimes other factors can offset the pressure on import prices. Every situation is different and depends on the variables at hand.
So by all means, keep an eye on potential currency market interventions if you are concerned about their unintended consequences and general record of creating winners and losers. But we don’t think presuming strong or weak currencies are inherently terrible or wonderful for stocks will work out well repeatedly.
[i] Data cited are the nominal trade-weighted US dollar index (broad currency basket) and the spot exchange rates of the US dollar per British pound, euro, Canadian dollar, Australian dollar, Japanese yen, Chinese yuan, Taiwanese dollar, South Korean won, Brazilian real and Mexican peso, 12/31/2021 – 9/30/2022. S&P 500 total return and MSCI UK IMI, Germany, France, Italy, Spain, Canada, Australia, Japan, China, Taiwan, South Korea, Brazil and Mexico index returns with net dividends in the aforementioned local currencies and USD, 12/31/2021 – 9/30/2022. Headline year-over-year consumer price inflation rates for the US (June and August), UK (July and August), Germany (September), France (July and September), Italy (September), Spain (July and September), Canada (June and August), Australia (Q2), Japan (August), China (July and August), Taiwan (June and August), South Korea (July and August), Brazil (April and August) and Mexico (August).
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