During the second half of 2014, nervous investors were fixated on the shifting economic fortunes caused by the precipitous decline in the price of oil. With oil showing signs of stabilizing near $50 a barrel, investor anxiety is now focused on a new worry: the explosive rise in the value of the U.S. dollar. The dollar has risen about 24% in the last twelve months against the euro, and about 16% versus the Japanese yen. In recent weeks, as the European Central Bank’s (ECB) efforts to stimulate growth through its own Quantitative Easing (QE) program have become clearer, the decline in the euro has accelerated.
Besides making that long-awaited trip to Paris or Tokyo a lot more affordable for U.S. residents, what are the ramifications of the dollar’s sharp rise on the financial markets?
First, let’s put the dollar’s recent rise in perspective. While it is true that the Trade Weighted U.S. Dollar Index (a measure of the dollar’s strength against currencies most widely used in international trade) recently reached a 12-year high, it is only at about its average level of the last 30 years. The dollar peaked about 20% higher than its current level in 2001 and more than 60% higher back in 1985. So from that perspective, we do not believe the dollar is wildly overvalued.
The dollar’s rise has been driven by the diverging economic paths of the U.S. (strong) and most of the rest of the world (weak), and the monetary policies being pursued by the Fed (planning to tighten) and other major central banks (easing). This has created a strong demand for U.S. assets, and one that is unlikely to change unless one of these preconditions is altered.
A strong dollar makes our exports to other countries more expensive, and makes imports to the U.S. cheaper. The lower cost of imports to the U.S. forces domestic producers to hold the line on price increases in order to maintain competitiveness, helping to keep inflation subdued. On the flip side, European exporters gain a competitive advantage because their goods are cheaper to U.S. buyers. While not an explicit goal of the ECB, the sharp decline in the euro is likely to stimulate demand for European exports (and travel from the U.S.), thus boosting European economic growth.
As is the case with most macroeconomic variables, there are both positive and negative economic effects from a strong currency. The strong dollar is likely to reduce overseas demand for U.S. exports, thus crimping the earnings prospects for U.S.-based multinational companies. That is the bad news. On the plus side, low inflation is considered a positive for the U.S. economy, in that it helps to keep interest rates down, stimulating demand for credit and investment.
The dollar’s ascent is likely to increase the appeal of U.S. assets, particularly bonds, to international investors seeking a strong currency and high (relative) yields. While U.S. equities may struggle for some time as earnings estimates are reduced, history shows that price-earnings multiples tend to increase when the dollar is strengthening. As a result, we do not expect the dollar’s rise to have a significant impact on equity prices. While European companies are likely to benefit in the short run, the longer term performance of European equities is more dependent on the efforts of the ECB to lift European GDP from the economic doldrums. We remain skeptical on that score.
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