Riding High with the USD

October 17, 2022 | Jonathan Yung


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The impact from a high dollar

During periods of heightened stock market volatility, investors commonly seek the liquidity and safety offered by the U.S. dollar. Moreover, a relatively more aggressive interest rate path by the Fed compared to other central banks has provided a yield advantage in U.S. Treasuries. This attracts more investment in U.S. denominated capital. Lastly, while the U.S. is by no means immune to inflation concerns, overall geo-political uncertainties, global growth headwinds, and international energy security issues have led to the perception that the US will be relatively more resilient.  Altogether, this general mood towards a ‘flight to safety’ increases the demand and price of the US dollar.

To put this demand in perspective, the U.S. dollar has reached levels that have not been seen in decades. Year-to-date, it has appreciated more than 20% relative to the Japanese Yen, nearly 15% relative to the Euro, and close to 20% relative to the British pound. The latter has perhaps been the most noteworthy as it has come under significant stress in recent weeks and now sits at a historic low relative to the U.S. dollar. The newly formed British government surprised investors by announcing that it would cut taxes to help its economy. That decision flies in the face of the Bank of England, who has been raising rates forcefully in an effort to lower demand and cool inflation. A week after this announcement, the U.K. suddenly pivoted and decided to abandon these tax cuts, further fueling the criticism of a disorderly government that continues to erode investor confidence.

As Canadians, we naturally pay the most attention to the Canadian dollar, which is also lower this year; however, by a far less noteworthy amount. At the time of this writing, the Canadian dollar has fallen by close to 7% relative to the U.S. dollar. Nearly half of that decline has come over the past month as the loonie had been quite resilient due to elevated commodity prices and an interest rate policy that has been just as aggressive, if not more, than the U.S. Federal Reserve.   Nevertheless, growth concerns have started to permeate across global markets, and commodity prices have recently weakened, leaving the Canadian dollar more vulnerable over the past month. Another source of concern is that the Canadian economy may be more sensitive to higher interest rates compared to the U.S. given our country’s higher level of household indebtedness.

With an elevated U.S. dollar, investors should understand the impact that a stronger U.S. dollar will have on their equities.

A stronger U.S. Dollar becomes a clear headwind for S&P 500 earnings, as global profits from different international regions will be lower when converted back to U.S. dollar terms. As the chart below shows, a rise in USD is normally accompanied by lower Earning Per Share (EPS) growth. This currency impact could begin to lengthen the cracks in Q3 earnings, which analysts have already begun to lower expectations due to a slowing economy and a more reserved consumer.

Historically, U.S. equity performance tends to be weak when the U.S. Dollar is strengthening, and EPS growth, in particular, tends to be weak or negative. However, there are nuances worth noting. One is that U.S. equities tend to outperform non-U.S. equities when the U.S. Dollar is strengthening. This may limit the downside in U.S. stocks on a relative basis since the perception is that the U.S. economy is more resilient and the U.S. consumer is in better shape than the European consumer.

Finally, if we look at the chart below, some sectors experience greater headwinds than others. Historically, EPS revision trends are less sensitive to a stronger U.S. Dollar in sectors such as Financials, Utilities, and REITs.

As for Canada, those that have U.S. operations or export to the U.S. should be able to benefit from a stronger U.S. dollar that will be translated back to more Canadian dollars. Sectors with greater U.S. revenue exposure include Technology, Financials, Health Care, Industrials, and Forestry. Those sectors that have less U.S. revenue exposure include Real Estate, Telecom, and Media. Finally, although commodities are generally priced in U.S. dollars, there are many other business factors, including hedging contracts that may offset the benefits from a sudden rise in the U.S. dollar. Therefore, it is slightly tricky to determine the net benefit of a rising U.S. dollar for Canadian energy and mining companies.

Bottom Line:

It is hard to know exactly where currencies go from here. Foreign exchange has been notoriously difficult to predict with any consistency throughout history. Yet, we recognize they can move to extremes from time to time, only to be then followed by a reversion to the mean. Hence, longer-term investors tend to experience a smoothing effect in currency fluctuations over time. At the moment, we recommend investors review and potentially rebalance their portfolio’s geographic and sector exposures with the lens of potential currency impacts. Further, converting some US dollars back to Canadian dollars to secure the recent currency gains may be a prudent activity in what has been a difficult year for most assets.

 

 

 

 

 

 

 

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