The U.S. dollar is dropping again following comments from U.S. Treasury Secretary Steven Mnuchin at the World Economic Forum in Davos, Switzerland. This is likely to have an impact on the market, but non-currency traders may not know that a falling or rising dollar doesn’t usually equate to a “bad” or “good” dollar. Often, a falling dollar is a good thing, which is likely the case for investors in 2018.
Theoretical Impact on Exporters
Imagine that you make and sell XYZ product in the U.S. for $500 and you could sell it in Germany at the end of 2016 for €500 when the two currencies were nearly at an equal value. The exchange rate has now changed, and it costs 1.24 dollars ($1.24) to buy a euro in 2018. Your German customers still must pay you $500 to purchase XYZ, but it only costs them €403.23 to “buy” enough dollars to complete their purchase.
In the XYZ scenario, you have an advantage in selling your goods to customers in Germany because it is relatively cheaper for them. This may give you an edge over competitors in China and the U.K. who have currencies that have not depreciated against the euro by the same amount.
Very often, U.S. manufacturers have a significant edge when the dollar is falling, and that should be good for earnings. You can see this striking, negative correlation in the following chart that compares the dollar (top) to the Industrial Select Sector SPDR Fund (NYSEARCA:XLI).
Impact on International Profits
A falling dollar has a similarly positive (if sometimes unrealized) benefit to companies that are bringing international profits back to their U.S. shareholders. Imagine that you own a company that made €1,000,000 at the end of 2016 from its operations in Germany, which could then be brought back to U.S. shareholders for $1,000,000 in earnings.
However, by today, that same €1,000,000 profit would be converted into $1,240,000 in earnings. The effect, in this case, is to benefit the bottom-line of companies with international operations. This is an important reason why the S&P 500 has been able to outperform small-caps as the dollar has been falling. Small companies tend to have much less exposure to the benefits of a falling dollar because they are more domestically focused.
Who Does This Hurt?
Assuming the dollar remains relatively weak, companies that import goods for domestic consumption are at a disadvantage. Consumer-goods retailers can be hit from rising import costs due to a falling dollar.
A declining currency can also trigger rising long-term interest rates because of inflation expectations. Over the last year, rising interest rates have had a negative effect on technology companies.
The Bottom Line
The net effect of a weakening currency is that it tends to provide a boost to stock prices. The risk to companies depending on cheap imports is usually much less than the benefit exporters and international firms experience. The change in Secretary Mnuchin’s tone towards the dollar isn’t bad as long as the dollar doesn’t decline outside of historical ranges. In the short-term, a weaker dollar is expected to provide support for stocks and keep drawdowns minimal.
You can learn more about identifying price patterns and using them to project how far you think a stock is going to move in our Advanced Technical Analysis Program.
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