Originally published on RGJ’s website, http://www.rgj.com/story/money/business/2015/03/20/uncertainties-driving-markets/25113763/
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.
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, because the foreign earnings translate into fewer dollars. 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 rapidly, it becomes very difficult to temper the impact to the income statement. Between 12/31/13 and 3/16/15 (14.5 months), the euro has fallen 23% vs. the dollar, the British pound is down 11%, the Japanese yen 13% and the Brazilian real 27%. Such moves are unprecedented.
In the normal course of business, under the scenario of a rapidly strengthening dollar, CFOs would be selling their foreign earnings forward, putting 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 one-year reprieve in that tax provision, and, according to Cumberland Advisor’s March 13 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, 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 2015’s first quarter, likely flowing into future quarters depending on the future behavior of the foreign exchange markets.
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, and job openings at record levels. Walmart, and now Toyota, 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? Some observations:
•The seasonal adjustment 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 to see the underlying trends. For example, data is seasonally adjusted to take into account the July Fourth holiday and it works pretty well. But, Easter has always been a recognized issue since it is a moveable holiday. 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 the SA process will underestimate underlying economic strength when 3 feet falls. This could well explain the apparent weakness in the recent data, and would square with the strength in the labor markets
•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.
The Fed: The Wild Card
According to economist David Rosenberg, the dollar’s strength, itself, is the equivalent of a 200-300 basis point tightening in monetary policy. And the Fed certainly doesn’t want to make the same mistake it made in 1937 when it tightened policy prematurely after the Depression and caused a significant economic relapse.
On Wed, 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. Here are some observations:
•The weak data discussed above probably keeps the Fed on hold at least until September.
•If they continue to convince the markets that they are on the 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 the rapidly strengthening dollar on corporate profits.
Conclusion
Expect continued equity market volatility as these events unfold.
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.