The end of the second quarter was eventful with the Brexit, but ultimately, there wasn’t much of a shift in investor expectations based on the price of the major indices.
While elusive growth seems to have had little effect on risk appetite, there are other factors that should hit the earnings reports this month that could finally crack support on the S&P 500.
One of the most serious issues that hit corporate earnings in 2015 was the value of the U.S. dollar. As you can see in the next chart, an extraordinarily robust rally in the dollar coincided with the 2015 consolidation.
ICE U.S. Dollar Futures
Pressure from a stronger dollar eased in the first quarter of this year, which helped lead to a rally in stocks and energy prices. However, from a technical perspective, the dollar has formed a “double-bottom,” which could indicate additional upside in the near term.
The problem with a stronger dollar is that it reduces the value of revenues from foreign sources. For example, the exchange rate between the U.S. dollar (USD) and the British pound (GBP) was $1.50 to £1.00 just before the Brexit vote. Imagine that a U.S. company was exporting equipment to the U.K. that was sold for £1,000 per unit. If they sold 500 units, they made £500,000, which would have been converted to $750,000 in domestic terms at that exchange rate.
On July 6, the GBP fell to a new low of $1.28 per £1.00. If this company sells another 500 units for £500,000, it can only be converted back to $640,000 — which is a decline of nearly 15% in USD terms — because the exchange rate changed.
The more the USD strengthens against the GBP, EUR, CAD or CNY, the more profits are at risk.
How Airline Stocks Fared
As you might imagine, the recent rally in the dollar will affect different companies at different rates. Sometimes a rally in the dollar doesn’t affect profits at all because growth is very strong.
Based on what we are seeing this month, a stronger dollar is probably not going to be positive for earnings. There are a few industries that tend to act as a gauge for whether the USD’s strength is likely to be a problem or not.
Airlines don’t do a lot of forward-selling, so they are exposed to volatility in the currency market more immediately than many other sectors with international exposure. Currently, airlines are already in a relatively precarious position, as per-seat revenues and transatlantic travel continue to disappoint.
At this point, we think airlines are fragile enough to serve as a very effective “canary in the coal mine.”
Delta Air Lines, Inc. (DAL) warned this week that passenger revenue would fall 5% in the second quarter, largely due to “continued weakness in foreign currencies” (aka a stronger dollar).
This might seem a little counterintuitive — after all, wouldn’t a stronger dollar mean U.S. travelers have more purchasing power to travel abroad?
The real issue is that any benefit to the U.S. traveler is being offset by the reduced purchasing power for foreign visitors heading to the U.S.
The decline in airlines stocks (see the following chart) may be more profound than it looks on the surface.
Delta Air Lines (DAL)
At the same time that currency pressures are hitting profit expectations and fuel costs are falling, which might normally be considered a positive. However, hedging and reduced growth expectations have offset that benefit enough to still send prices lower.
Activity in a single sector isn’t enough to draw market-wide conclusions. However, it’s a valid early warning that we will be monitoring. If the dollar reverses on GBP and EUR strength, then the S&P 500 may be spared, but the strong trend in bonds and yields would argue that the odds are stacked against that scenario.
In the meantime, a cautious outlook for support on the major indices seems justified.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
