Are You Prepared for a Stronger Dollar?

by Daniel Putnam | December 3, 2013 8:03 am

What would happen to the stock market if the U.S. dollar rallies?

It’s a question that isn’t getting much press, but investors may want to take a closer look. The fluctuations in the dollar can have a significant impact on the performance of individual stocks, certain sectors, and the market as a whole, so it pays to be aware of events in the currency markets at all times.

The year ahead, in particular, COULD prove to be a time in which currencies are a key factor in stock market performance.

A More Accomodating ECB Could Weaken the Euro

The U.S. Dollar Index (DXY) stands well below its 2001 peak, and it is largely unchanged from its level of six years ago. During this time frame, however, there have been a number of upward spikes: late 2008, early 2010, and 2011-2012. With the dollar having been relatively stable for two years, investors may be lulled into the expectation of continued currency stability.

usd Are You Prepared for a Stronger Dollar?[1]

That shouldn’t necessarily be the case. While the U.S. Federal Reserve’s quantitative easing has helped keep the dollar from establishing upside momentum against the basket of currencies represented in the index, this obscures what’s happening underneath the surface. The dollar has gained substantially against the yen on a year-to-date basis, as gauged by the loss of nearly 15% for the CurrencyShares Japanese Yen ETF (FXY[2]).

The primary cause of dollar-yen strength has been the exceptionally aggressive monetary policy being employed by the Bank of Japan, which — as a percentage of the country’s economy — far exceeds the extent of the Fed’s quantitative easing.

Now, a similar dynamic may be set to unfold with respect to the euro.

The European Central Bank surprised the markets earlier this month by cutting rates and leaving open the possibility of employing negative interest rates to stave off deflation.

Ardo Hansson, a member of the European Central Bank Governing Council, was quoted by Bloomberg this week as saying:

“The options on rate cuts are still not fully exhausted and there are all kinds of other measures that are still on the table. Of course, every time you use one option, you have one less to use. But I don’t see us, by any means, running out of our toolkit of things we can draw on.”

The ECB’s more aggressive stance comes at a time in which the U.S. Federal Reserve continues to contemplate the possibility of tapering. While the estimates as to when a taper could actually begin are all over the map, the consensus is that the process could begin in the first half of 2014.

This sets up a scenario in which the Fed is becoming less supportive even as the ECB is becoming more forceful, which in turn would be positive for the dollar against the euro. This shift was reflected in the initial reaction to the rate cut in the CurrencyShares Euro ETF (FXE[3]), which fell from $136.58 to $132.12 in the ten sessions from Oct. 25 through Nov. 8.

If the euro were indeed to experience more sustained weakness on the dollar, the market impact could be more substantial than what has been brought about by the dollar-yen move of the past six months. Europe is a more important trading partner for the United States, and it represents a much larger portion of the U.S. Dollar Index than the yen: 57.6% versus 13.6%.

The Implications of Dollar Strength

If the stronger-dollar scenario indeed unfolds, what could investors expect?

The first outcome would likely be a more challenging environment for the market. Multinational companies that earn a large portion of their revenues overseas could be impacted negatively by a stronger dollar, among them 3M (MMM[4]), Phillip Morris International (PM[5]), Avon Products (AVP[6]), International Business Machines (IBM[7]), Texas Instruments (TXN[8]), and Oracle (ORCL[9]).

On a sector basis, a rising dollar would likely have a disproportionately negative impact on materials and technology stocks, which have exhibited the highest negative correlation to the greenback. Gold stocks, in particular, would face further challenges if the dollar were to pick up steam. Energy stocks could also be vulnerable given crude oil’s sensitivity to currency movements.

On the other side of the equation, health care and financial stocks have shown the lowest negative correlation with the dollar, indicating that these groups could outperform in a strong-dollar scenario.

Third, and perhaps most important, investors in unhedged international funds would likely experience underperformance barring substantial gains in the underlying markets. One solution to that problem would be currency-hedged ETFs. Year-to-date in 2013, the weak yen has led to substantial outperformance for the WisdomTree Japan Hedged Equity Fund (DXJ[10]), up 35.5%, relative to the iShares MSCI Japan ETF (EWJ[11]), which is ahead 24.3%.

In the coming year, funds such as WisdomTree Europe Hedged Equity Fund (HEDJ[12]) or the db X-trackers MSCI EAFE Hedged Equity Fund (DBEF[13]) — both of which have lagged their unhedged counterparts in 2013 — could see a similar benefit.

The Bottom Line

The currency markets are notoriously fickle, and making investment decisions solely on the basis of expected performance for the U.S. dollar is unwise. However, given the possibly divergent paths of the Fed and ECB, investors need to be on alert for the implications of currency movements in the year ahead.

Keep a close eye on the dollar-euro relationship as we move into 2014.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Endnotes:
  1. [Image]: http://investorplace.com/wp-content/uploads/2013/11/usd.gif
  2. FXY: http://studio-5.financialcontent.com/investplace/quote?Symbol=FXY
  3. FXE: http://studio-5.financialcontent.com/investplace/quote?Symbol=FXE
  4. MMM: http://studio-5.financialcontent.com/investplace/quote?Symbol=MMM
  5. PM: http://studio-5.financialcontent.com/investplace/quote?Symbol=PM
  6. AVP: http://studio-5.financialcontent.com/investplace/quote?Symbol=AVP
  7. IBM: http://studio-5.financialcontent.com/investplace/quote?Symbol=IBM
  8. TXN: http://studio-5.financialcontent.com/investplace/quote?Symbol=TXN
  9. ORCL: http://studio-5.financialcontent.com/investplace/quote?Symbol=ORCL
  10. DXJ: http://studio-5.financialcontent.com/investplace/quote?Symbol=DXJ
  11. EWJ: http://studio-5.financialcontent.com/investplace/quote?Symbol=EWJ
  12. HEDJ: http://studio-5.financialcontent.com/investplace/quote?Symbol=HEDJ
  13. DBEF: http://studio-5.financialcontent.com/investplace/quote?Symbol=DBEF

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