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The Implications of a Rising Dollar

As fear has crept its way into global markets, investors around the world are seeking the comfort of safe-haven assets such as the U.S. dollar and gold. Staying true to what Ray Dalio (Trades, Portfolio) predicted in last July, gold has soared more than 8% so far in 2020, once again proving of its ability to deliver stellar returns during turbulent times in capital markets. The greenback is living up to expectations as well. On Feb. 19, the U.S. Dollar Index reached a high of 99.577, which is the highest level recorded since May of 2017.


Source: Bloomberg.

UBS head of asset allocation for the Americas, Jason Draho, told the Wall Street Journal last week:


"The most plausible explanation for ongoing dollar strength is that investors globally want to own U.S. assets because they have the highest confidence in the U.S. economy doing fine, which is more of a flight to conviction, not safety."



The impacts of a rising dollar will be felt across business sectors on a global scale, so understanding the implications of this development is essential to making the necessary changes to investors' portfolios to secure sustainable returns.

The relationship between the dollar and corporate earnings

When American companies deliver stellar financial performance and beat analyst estimates, stock prices tend to follow suit. A dent in profits, on the other hand, could lead to a severe downturn in capital markets, and the financial crisis of 2008 is a classic example of such a phenomenon. When the dollar strengthens against other major currencies, American products become expensive in global markets. This might lead to a decline in exports, which is a negative development for the economic growth of the country. The U.S. government has unveiled its plan to make the country's products more competitive in global markets, and President Trump, on several occassions in 2019, blamed the soaring dollar for not helping the cause. If the currency strengthens any further in the near future, companies that depend on international markets might issue revenue warnings. For consumers, however, this could turn out to be good news as imports become cheaper.

A headwind for oil prices

The COVID-19 virus is proving to be a threat to oil prices, but troubles don't seem to end there for the industry. Historical evidence suggests that a strengthening dollar will be bad news for energy prices. According to economic theories, there are two reasons for this:

  1. Commodity prices are quoted in U.S. dollars. Therefore, a rise in the currency means that it would take fewer units to buy a barrel of oil, all else equal.
  2. The U.S. has been a net importer of crude oil throughout history. Therefore, a rise in oil prices would lead to a larger trade balance deficit as more greenbacks would be sent abroad.



Source: Federal Reserve.

The inverse relationship, however, has become less strong in the recent past as the United States now is a net exporter of oil as a result of increased drilling activities. As of 2018, the U.S. topped the list of largest oil-producing countries in the world.

Source: U.S. Energy Information Administration.

Even though this is relieving news for energy investors, the negative correlation between the two variables has not entirely diminished. Therefore, as the dollar continues to gain traction against other currencies, oil prices can be expected to take a hit. A slowdown in global economic growth driven by the spread of the coronavirus will add salt to the wound as it would reduce the demand for the commodity.

There's no need to panic, though. As Peter Lynch explained in December, the long-term outlook for energy prices is promising. Therefore, contrarian investors should look for attractive opportunities in today's markets in a bid to capitalize on future price gains.

Not good news for emerging markets either

There's a lot to like about developing countries. The expected economic growth in these regions is considerably higher than that of North American countries and Europe, equity market valuations are relatively cheap and these stocks provide much-needed diversification benefits to American investors. However, the strengthening dollar is not a welcome sign for the performance of emerging market equities. According to data from BlackRock (NYSE:BLK), this is the asset class with the highest negative correlation with the U.S. dollar.

Source: BlackRock.

Servicing debt denominated in dollars becomes a challenge for these nations as more units in the local currencies would be required to buy the greenback. According to BIS International, Brazil, Chile, China, India, Indonesia and Korea are at the highest risk of a strong dollar as these countries have the largest outstanding amounts of dollar-denominated bonds. An investor with exposure to emerging market stocks should ideally take measures to diversify within the asset class to minimize the risk of high concentration in any one of these economies.

It's time for small companies to shine

As highlighted in an article published in December, large U.S. companies have outperformed their smaller peers over the last half a decade by a healthy margin, but there are a few developments that point to the opposite happening in the next several years. A strong dollar would be a nice compliment as well. Unlike multinational organizations, companies with limited access to capital and other resources primarily sell their products and services to American consumers. However, many of these companies might depend on raw material imports from China, Brazil, Hong Kong and other Asian countries. A strengthening dollar makes imports cheaper, presenting an opportunity to expand profit margins. Even though this is applicable for large companies as well, the caveat is that a high percentage of their sales come from outside the U.S., thereby offsetting the benefits of low raw material costs. Investors can either use an exchange-traded fund or invest prudently in a basket of small-cap stocks to benefit from a higher dollar.

Takeaway

Macroeconomic factors can and will have lasting impacts on capital markets. The strengthening U.S. dollar is one such development that has the potential to disrupt the market performance and tilt the odds in favor of some companies and industries, while making survival difficult for others. At the current level, however, the dollar will likely not trouble the markets. The real risk is the possibility of an additional increase.

Liz Ann Sonders, chief investment strategist at Charles Schwab (SCWH), told MarketWatch:


"A stronger U.S. currency eventually could present a headwind to stocks, but it would likely take a further run-up."



In any case, preparing for the worst is the best action investors can take today. Rather than waiting for the risk to materialize, building a diversified portfolio with equity securities of many international markets, investing in small-cap stocks and de-risking by taking profits off overvalued companies are some of the actions that investors might want to consider to secure sustainable long-term returns.

Disclosure: I do not own any stocks mentioned in this article.

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This article first appeared on GuruFocus.