The financial markets have been focused on three uncertainties: the strong and rising value of the dollar vis a vis other currencies, weakening U.S. economic indicators, and the timing and magnitude of Fed policy actions. All this with a background of the ongoing Greek tragedy and continued political strife and terrorism worries. Volatility has resulted. To show the market’s uncertainty, in the month of March, of the 19 trading days through Thursday, March 26, 6 days have shown gains of triple digits in the Dow Jones Industrials, while 8 days have shown triple digit losses. That is, by far, most of the days. In 6 of those days, the gains or losses exceeded 200 points. In addition, in 17 of those 19 trading days, the difference between the market’s high and low for the session was more than 100 points, and in 8 of them, more than 200 points.
The Strong Dollar
The rising value of the dollar impacts the reported profits of multinational corporations as they translate their foreign exchange into U.S. dollars. By way of example, assume a company makes $1 billion in its U.S. operations, and €1 billion in its foreign operations. Assume that on December 31, the value of the euro was $1.25. The company would report $2.25 billion ($1 billion from U.S. operations and $1.25 billion from foreign operations after currency translation) in its annual financial report. Now, assume the following year that the exact same income is achieved in each operating theater, all the way down to the exact same sales by company product (i.e., $1 billion and €1 billion), but the euro has fallen in value to $1.00 (i.e., “parity”). Reported earnings now fall to $2.0 billion, or by 11.1% without any real change in economic activity. This is the issue facing the CFOs of U.S. multinational corporations today.
Normally, a gradually strengthening currency can be managed if the growth rate in the company’s business exceeds the growth in the value of the currency. However, when the currency strengthens so rapidly, it becomes very difficult to temper the impact to the income statement. The table below shows the changes in the value of the world’s major currencies relative to the dollar for the 14.5 months encompassing all of 2014 and the first quarter of 2015 (through March 16).
As the table shows, the dollar has gained significantly against most major currencies, the exceptions being the RMB and the rupee. The Chinese government carefully monitors the RMB and has basically tied it to the dollar; whereas the Indian rupee has performed well since its new government was formed and its central banker named, as this country then began to follow more conventional fiscal and monetary policies. In 2013, however, the dollar advanced significantly against the rupee.
In the normal course of business, under the scenario of a rapidly strengthening dollar, CFOs would be selling their foreign earnings forward, putting some upward pressure on the value of the dollar. But, U.S. tax policy has exacerbated that pressure. The U.S. taxes foreign earnings at 35% as they are repatriated. In 2004, the Bush Administration allowed a 1 year reprieve in that tax provision, and, according to Cumberland Advisor’s March 13th economic commentary, $300 billion flowed back to the U.S. Today, it doesn’t appear that we will see another such tax incentive during the remainder of the Obama Administration. According to Cumberland, there are $2 trillion of non-repatriated earnings out there. So multinational CFOs are not only converting their current profits from local currencies to dollars, they are also converting much of those $2 trillion of balance sheet holdings (un-repatriated profits) from their local currencies, putting significantly more upward pressure on the value of the dollar.
The result has been the rapid upward spike in the value of the dollar as shown in the table, and this has been an issue for the equity markets as analysts try to estimate the impact on earnings going forward. For sure, there will be a dramatic impact in 2105’s first quarter, likely flowing into future quarters depending on the future behavior of the foreign exchange markets, much of this heavily dependent on the Fed. (Note: Since March 18 when the Fed’s Open Market Committee’s statement was more “dovish” than the market expected, the dollar has given back some of its gains, but underlying conditions haven’t really changed, so we expect the dollar’s value to continue to move upward over the next few months or quarters.)
Weakening Economic Data?
Almost all of the data from February have been much weaker than expected, except for the employment data (which have been on fire). The economy has created, on average, more than 320,000 net new jobs per month since November. Layoffs are down, “jobs hard to fill” rising, voluntary quits up, new claims for unemployment insurance down, and job openings at record levels. Walmart, and now Toyota and Target, have begun a process to raise their wage scales, mainly as defensive moves to keep their current employees. When employment is this strong, economic growth always follows. So, why is the incoming data so weak? I have some observations:
- Those whose parents or grand-parents lived through the Great Depression tell stories about how frugal these people became and how they shunned debt. We could be seeing a similar, but weaker, psychological phenomenon from the Great Recession. Several recent surveys have shown that the savings recently seen at the pump are being used to pay down debt and increase savings; only 25% has been going to additional spending. Perhaps U.S. consumer psyches are still reeling from the Great Recession.
- The second, and probably more relevant, observation is that the seasonal adjustment (SA) process just can’t handle the extremes in weather for much of the nation. SA is a statistical process that attempts to remove influences caused by things such as holidays, summer vacations, etc. so that monthly data can be compared without such distortions. For example, data is seasonally adjusted to take into account the July 4th holiday. And, that usually works pretty well. But, Easter has always been a recognized issue for the SA process since it is a moveable holiday and in some years it lands in March and in other years it lands in April. In addition, any rapid changes in traditional behavior, like the movement of holiday sales outside of the traditional Black Friday to Christmas period, also causes problems in the seasonally adjusted data. Simply stated, SA uses historical averages to adjust the data. So, when extremes occur, especially in weather, the process doesn’t work very well. There is a big difference in business activity when snowfall is 6 inches than when it is 3 feet. And, if the average is 6 inches, then when 3 feet falls, the SA process will underestimate underlying economic strength. This could well explain the apparent weakness in the recent data, and would square with the strength in the labor markets. Also, we will know if this is the case as the data unfolds during the spring (March, April and May data).
- Compounding the issue this year was the west coast port strike which played havoc with inventories and production schedules. The strike was settled late in February, so, like the SA issue, we could very well see a strong bounce back in the data as spring arrives beginning in March.
The Fed – the Wildcard
According to economist David Rosenberg, the dollar’s strength, itself, is the equivalent of a 200-300 basis point tightening in monetary policy. Today’s Fed will be very careful not to make the same mistake it made in 1937 when it tightened policy prematurely after the Depression and caused a significant economic relapse.
On Wednesday, March 18, the Fed removed the word “patient” from their official statement but reiterated that they would wait for enough data to satisfy themselves that the economy was on solid footing, and deflation was not a threat, before raising rates. This indicates that when the data are all on strong trends, the Fed will feel free to raise rates, i.e., the raising of rates is “data dependent.” Some observations:
- The weak data discussed above probably keeps the Fed on hold for the first rate increase at least until September;
- If they continue to convince the markets that they are on course to actually raise rates, then the dollar will continue to strengthen, as every other major central bank is now in easing mode, either lowering rates, printing money, or both;
- Historically, the equity markets, after a short pause when the first rate hike occurs, continue their upward trends for several more quarters, usually until a recession is approaching. The complicating factor here is the headwind caused by a strengthening dollar on corporate profits. Offsetting this is the desire of those holding other currencies to hold assets in a currency that is appreciating. So, a partial offset to the headwind described above is the demand for dollar based assets, much of which ends up in the U.S. equity markets and, if corporate profits are stagnating, shows up in rising P/E ratios.
- The strong dollar is a headwind to U.S. multinational profits, and current U.S. tax policy only exacerbates this situation;
- The weak economic data, of late, is a contradiction to the very strong labor market. The seasonal adjustment process may be part of the issue, along with the west coast port strike;
- The Fed is the wild card. The coming hike in short-term rates is clearly now “data dependent.” Thus, the weak data, of late, would appear to put the first rate hike out to September, at the earliest. The Fed is clearly poised for rate hikes while the rest of the world is in easing mode. This is going to put more upward pressure on the dollar’s value, potentially causing headwinds for corporate profits for several quarters to come.
- Expect continued equity market volatility as these events unfold.
Universal Value Advisors
Robert Barone, Ph.D.
Andrea Knapp Nolan
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee. Robert is available to discuss client investment needs. Call him at (775) 284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.