In general, the foreign exchange between two currencies tends to reflect the relative economic growth of the two regions, the differing interest rate expectations as telegraphed by the central banks, and the variety of geopolitical tensions facing each country. This year, the U.S. dollar index (DXY), an indicator frequently used by traders to measure the value of the USD against a basket of currencies, hit a high of 114.78 in September. At the time, this represented a 20% rise year-to-date. Since then, the DXY has gradually declined -7.5% from the highs. Moments of noticeable volatility in the U.S. currency often raise questions about how this affects the companies that are underlying one’s portfolios.

Broadly, a strong U.S. dollar has a negative impact on U.S. corporate earnings. This can become a concern for investors as many U.S. companies receive their profits overseas. Within the S&P 500 index, nearly 40% of company profits come outside of the U.S. and those foreign profits are reduced by exchange rates when translated back to a strong U.S. dollar. Hence, when the U.S. dollar rises, earnings tend to decline and when the U.S. dollar falls, earnings tend to increase. Since 1985, as the chart below illustrates, SP500 Earnings Per Share (EPS) has gained an average of +0.03% per annum when the U.S. Dollar’s 4-quarter % change is greater than 0%; however, when the % change is below 0%, the EPS gains averaged +15%.

From above, a higher dollar that leads to lower EPS may seem like a bad omen for stock prices. However, equity market valuations have historically adjusted higher during these periods of U.S. dollar strength. Hence, P/E valuations have risen with an increase in the U.S. dollar and valuations contract when the U.S. dollar is weakening. In our opinion, this could possibly be explained by the idea that a stronger US dollar may reflect a strong economy and more demand for the U.S. currency, which begets greater demand for assets denominated in USD. This ultimately leads to PE multiple expansion.

Therefore, with the benefit of PE expansion, since 1985, the S&P500 has been able to gain an average of 7% whenever the 12month change in the U.S. dollar is greater than 0%. Even though the gains for the S&P500 are greater when the U.S. dollar falls over a 12 month period, ultimately. the implication is that PE multiple expansion is enough to counteract the drop in EPS and propel stock prices higher.

In all, a strong U.S. dollar is a negative for earnings in an absolute sense but historically speaking, valuations adjust higher, and stock returns have risen despite the trend of the dollar. For long-term investors, we believe investors should focus more on sector and asset mix decisions rather than how the direction of the dollar may influence stock prices in the short term.