A two-decade high for the dollar … why its strength is so bad for earnings … the second way a strong dollar hurts stocks … relief from Europe?
That’s the thing about bear-market rallies – they’re very convincing.Congrats to everyone who answered “King Dollar.”Yesterday, we watched the last few drops of the summer bear-market rally swirl down the drain, as the S&P set a fresh low for 2022. As I write on Tuesday, this morning’s rally has fizzled. All three indexes were up roughly 1% (the Nasdaq was up 1.6%). But they’re all in the red at the moment, though who knows where they’ll be when you read this. U.S. stocks face a laundry list of problems. But let’s zero in on one in particular – one that was responsible for billions of losses in Q2 earnings. For example, this problem cost IBM $900 million in Q2. And the tech giant expects the issue will shave about 8 percentage points off of its Q3 results. For Pepsi, its Q2 earnings were 2% lower than they’d have otherwise have been because of the problem we’re about to discuss. Johnson & Johnson’s Q2 revenues took a huge hit, but the bigger issue was its full-year forecast. Management said that revenues could come in about $4 billion lower for the year due to this issue. For Philip Morris, the Q2 hit was $500 million… For Netflix, it was roughly $350 million… This is a widespread issue. In fact, the investment research shop LPL estimates it lowered Q2 revenue for the entire S&P 500 by two to two-and-a-half percentage points. That’s billions of dollars, up in smoke. Now, here’s the punchline… It’s going to be worse in Q3. Know what it is?
Why dollar strength is so painful for multinational companies
I get it – currencies are boring. And are they really that big of a deal to your portfolio?Well, studies show that currency fluctuations tend to net-out over longer periods of time. But over shorter periods, currency volatility can be a huge deal. We’re in such a period. A strong dollar hurts U.S. companies that sell their products abroad in one of two ways. To illustrate the first, imagine that you have a business that sells products in France. In the past, French customers have bought your product in euros, and after the currency conversion back to dollars, you’ve banked $100 for each sale. But let’s say the dollar becomes much stronger against the euro. Meanwhile, let’s say that the price of your product in euros has remained the same. So, the same French customers buy your product for the same old price in euros. But because the dollar is stronger, when we exchange those euros back into dollars, that sale only contributes, say, $95 to your bottom-line. Your earnings take a hit. As to the second way a strong dollar can hurt, let’s assume that you have some say over the pricing of your product in euros. You choose to raise the price to offset the currency headwind. Well, now you’re dealing with French customers with sticker-shock, some of whom will refuse to buy at this new, higher price. So, rather than taking that $5 hit to your bottom line, now you’re missing an entire sale. Okay, so currency issues can be a problem. But it’s a bigger problem than you might think. That’s because roughly 50% of the S&P 500’s revenues are international. So, yes, it’s widespread, and very likely to be impacting your portfolio, right now.
A problem of historical scope in the making
The dollar is now at a 20-year high – and it’s currently going parabolic.You can see this by looking at the U.S. Dollar Index below. This is a measure of the value of the U.S. dollar relative to the value of a basket of six major global currencies – the Euro, Swiss Franc, Japanese Yen, Canadian dollar, British pound, and Swedish Krona. Here’s its performance over the past 20 years:
So, we have a historically strong dollar barreling through global economies like a wrecking ball.How do you think that will impact Q3 earnings season that begins in just a few weeks? Well, here’s FactSet, which is the go-to earnings data analytics company used by the pros:
For Q3 2022, the estimated earnings growth rate for the S&P 500 is 3.2%. If 3.2% is the actual growth rate for the quarter, it will mark the lowest earnings growth rate reported by the index since Q3 2020 (-5.7%).…Ten sectors are expected to report lower earnings today (compared to June 30) due to downward revisions to EPS estimates. …Both analysts and companies have been more pessimistic in their earnings expectations for Q3 compared to recent averages. As a result, estimated earnings for the S&P 500 for the third quarter are lower today compared to expectations at the start of the quarter. On a year-over-year basis, the index is expected to report its lowest earnings growth since Q3 2020.
The strength of the dollar is a major contributing factor to why these earnings forecasts are coming in lower.Goldman Sachs estimates that a 10% appreciation in the dollar reduces earnings by companies in the S&P 500 by roughly 2%-3%. Well, since July 1 (the beginning of Q3), the U.S. Dollar Index has climbed 9.15%.
That’s pretty much a 3% earnings haircut right there.But the hit to earnings isn’t the only reason why a strong dollar is a problem for your portfolio…
A collapsing yen, a surging 10-year Treasury yield, and what that means for your wealth
The Japanese yen is one of the most important currencies in the world.It’s also been in a significant downtrend against the dollar that has accelerated sharply here in 2022. As you can see below, since January 1, 2021, the yen has lost 29% to the dollar.
As you can see, the pain accelerated here in 2022. The carnage has become so severe that the Japanese government finally intervened last week.From CNN Business:
Japan tried to shore up the value of its currency Thursday by buying yen and selling US dollars for the first time in 24 years.The yen had earlier plunged to its lowest level since 1998 after the Federal Reserve hiked interest rates aggressively while the Bank of Japan kept its rates in negative territory in a bid to boost its fragile economic recovery. The currency has lost about 20% this year against a surging US dollar.
Clearly, this is bad for U.S. companies that sell products in Japan, but if you don’t invest in those companies, why is this relevant to you?
Here’s a clue from that same CNN Business article:
Japan was believed to have been selling dollar-denominated assets it holds, such as US Treasuries, Japanese news agency Kyodo reported.
See the problem?Selling U.S. Treasuries… For any readers less familiar with the interplay between currencies, bonds, and stocks, let’s make sure we’re all on the same page… Heavy selling of any asset means there’s more of that asset on the market – this dynamic pushes prices lower. When it comes to bonds – say, the 10-year Treasury bond – there’s an inverse relationship between prices and yields. As price goes lower, yields go higher. So, as the Japanese government sells U.S. bonds and buys yen to prop up its currency, this applies upward pressure to U.S. bond yields…like the 10-year Treasury yield. And what asset class doesn’t like rapidly-rising, sky-high 10-year Treasury yields? U.S. stocks. This is for two reasons: One, bonds with soaring yields become a viable investment alternative to stocks. For example, today, you could invest in a two-year Treasury and earn 4.217%. And if you hold it to maturity, there’s zero risk of principal loss (unless the U.S. government implodes). Compare that 4.217% to the S&P’s current dividend yield of 1.73%. The second reason stocks hate lofty treasury yields is because the higher that yields go, the higher the “risk free” rate that Wall Street uses in its valuation models when it tries to put a fair value on stock prices. In general, the higher this risk-free rate, the lower the forecasted stock price. I guess now would be a good time to mention that the yield on the 10-year Treasury is up nearly 500% (not a typo) in the last two years, with the gains going near-vertical since August.
Back to stocks not liking a rapidly climbing 10-year treasury yield, here’s a close-up of the S&P collapsing under the weight of this surge since mid-August.
If the global currency situation continues to deteriorate and we see more foreign governments selling U.S. treasuries, the more pressure U.S. stock prices will experience.Hopefully, this dynamic will not persist. We want to see the 10-year yield pull back and take pressure off U.S. stocks. It also would be great to see the Dollar Index take a meaningful breather. This effort would get a boost if the European Central Bank decides to supercharge its rate hikes. Doing so would ease the downward slide of the euro to the dollar, which is back to parity.
Looking ahead, Q3 earnings season begins in earnest in the second full week of October when the big banks report earnings. We’ll keep you updated on how they come in.In the meantime, keep your eye on the U.S. Dollar Index and the 10-year Treasury yield (sitting at a nosebleed 3.925% as I write). The higher they go, the harder it will be for stocks to begin carving out a bottom and climb. Have a good evening, Jeff Remsburg