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  1. Home
  2. / Markets
  3. / Currencies

By George, Here's How Equity Investors Should Play the Almighty Dollar

For the stock market, dollar strength and Fed tightening are the same trade.
By BRAD GINESIN
Jul 19, 2022 | 11:40 AM EDT
Stocks quotes in this article: MS, MSFT

As of late, the strength of the U.S. dollar has burst into the news. Last week, the greenback hit parity to the euro for the first time in 20 years. On Saturday, a top story in the New York Times recounts the problems created by the outsized dollar appreciation versus most world currencies, while pundits think the strong dollar portends weak earnings ahead and another leg down for the stock market.

The strong dollar is a good news/bad news story.

The good news for the U.S. is that it helps lower import and commodity prices, which can tame inflation; exactly what is needed for the Fed to ease up on interest-rate increases. The inflow of dollars also lowers U.S. interest rates as demand for Treasury bonds strengthens. Recent auctions of long-term Treasuries have seen stellar demand from foreign sources, lowering long-term rates.

There is also good news that dollar valuation bears have been wrong for now. Most pundits concerned with inflation from Fed balance sheet expansion and M2 growth have been dollar negative. Conversely, dollar strength and the reining in of money supply should be a welcome inflation salve. Relatedly, the rise of cryptocurrencies was, in part, a bet against fiat currencies and the associated money printing -- the system has not been upended and supplanted by crypto.

The bad news concerns mainly the rest of the world: The strong dollar makes inflation more acute in countries where currencies are weakening. Commodities priced in dollars and other dollar-based goods raise import prices in most foreign countries. This importing of inflation can be fought by raising interest rates to support a weak currency, yet it also has the negative effect of slowing the local economy. The balance between inflation and economic weakness is a challenge for central banks worldwide.

The other negative effect of dollar strength is that U.S. multinational companies earn fewer dollars abroad when converted from a weak foreign currency back to dollars. The dollar index is up about 16% year over year, causing a significant headwind to the earnings of large multinationals.

According to Morgan Stanley (MS) strategist Mike Wilson, "The simple math on S&P 500 earnings from currency is that for every percentage point increase in the dollar on a year-on-year basis it's approximately a 0.5x hit to EPS growth. At today's 16% year-on-year level, that translates into an 8% headwind for S&P 500 EPS growth, all else equal."

In a bear market, investors often overreact to negative news. Dollar strength will have a material effect and lead to earnings disappointments for top U.S. companies, causing troubling headlines (e. g., Microsoft (MSFT) already pre-announced softer earnings due to the strong dollar, especially relative to the Japanese yen.)

For the stock market, dollar strength and Fed tightening are the same trade. When it's clear the Fed will pivot away from rate hikes, the dollar ought to also pivot and trend to weaker levels, alleviating inflationary pressure abroad and potentially reversing global recessionary concerns.

With the Fed expected to raise rates another 75 basis points at its next meeting in late July, the Fed pivot is probably not until the early fall. That can line up well with a durable bottom and an end to the bear market. For now, overreactions to weaker earnings from the strong dollar could lead to the best buying opportunities of the year.

Dollar strength alone has never been a good reason to sell stock, but it does currently add another gust to the headwinds this market faces.

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At the time of publication, Ginesin had no positions in any securities mentioned.

TAGS: Currencies | Earnings | FOREX | Markets | Stocks | Trading | Europe | U.S. Equity

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