The Dollar Is a Double-Edged Sword

The poor greenback just can’t win. When it is weak, people fear it fanning inflation, signaling slow growth or some other malaise. But a strong dollar doesn’t make many happy, it just morphs the fear. Today, the latter—strong dollar worries—abound. Some warn this is bad for the US economy and earnings. Others warn it is bad for all the countries whose currencies are weaker. This cognitive dissonance alone should be enough to disprove the notion that currency swings have a preset impact.

Currencies trade and move in pairs. There will always be weaklings and, uh, stronglings. If people are being logically consistent, they can’t simultaneously fear that a strong currency is awful for one nation and weak currencies are bad for the others. If strong is bad, then weak should be good. If weak is bad, strong should be good.

To understand why, let us consider the argument for a strong dollar hurting US businesses. A Wall Street Journal piece summed it up late last week, pointing to the strong dollar’s deleterious impact on US companies’ overseas revenues: “S&P 500 companies that derive more than half of their revenue outside the U.S. are on pace to post an 18% slide in second-quarter earnings, according to FactSet data through Aug. 30 that include 98% of S&P companies. In contrast, companies with more than half of their sales in the U.S. are poised to record 4% earnings growth.”^[i] The split, we are told, is down to the strong dollar making goods and services more expensive overseas, cutting sales and whacking margins.

Well, by that logic, a weak currency should be rock-solid awesome for everyone else. It should, theoretically, mean their exports will cruise to glory, either because eager Americans will snap up their wares at cut prices, boosting sales volumes—or because they can hold prices steady here while reaping big profits from currency translation. Given China, Japan and other Asian nations with weak currencies are export powerhouses, this should be excellent news.

Except it isn’t.

Governments across the region are jawboning about intervening to stop speculators from driving their currencies even lower. In Japan, a vice finance minister said the yen’s rapid weakening brings “uncertainty to businesses and households, which will have a negative impact on the economy.”^[ii]

The negative here? Import costs. When your currency is weak, you pay more for raw materials, intermediate parts and labor sourced overseas. The sticker price stays constant, but you have to pony up more of your home currency to pay the bill in the stronger currency. So when the yen, yuan and all the rest are weak relative to the dollar, exporters may gain an advantage selling final goods into America, but higher import costs can erode the edge.

Buuuuuuuuuuuuut, the flip side of this is the silver lining of a stronger dollar for US businesses. They get the benefit of cheaper import costs. Cheaper raw materials. Cheaper components. Cheaper overseas labor. This helps offset the dollar’s impact on revenues.

So in short, for US companies, a stronger dollar can hit sales while reducing costs. And for overseas companies, their weaker home currencies can boost sales while raising costs. Which is the better path depends entirely on the business. For some, the cost side is more important to margins than the revenue side. For some, the opposite. Some hedge all of this stuff. And in our experience, a lot of them use currencies as a scapegoat for disappointing earnings, much like blaming bad weather.

Here is the thing, though: If currencies were actually a huge influence on earnings, we would see it in stock prices via a strong negative correlation between US and international returns. Again, currencies trade in pairs, so logically, if currencies mattered, the dollar would lead US stocks in the opposite direction from Europe, Asia and the rest of North America. But US and non-US stocks have a resounding positive correlation of 0.83 over the past 20 years.^[iii] Considering a correlation of -1.00 means two variables always move in opposite directions, 0.00 means no relationship and 1.00 means they always move together, 0.83 means they move together vastly more often than not. Despite all the currency zigs and zags—even big ones—along the way.

This is why we see currency fears more as a sign of sentiment than anything else. The dollar is one of those things people latch on to when they are already anxious, no matter what it is doing. If it is strong, they find the negatives. If it is weak, they find the negatives. But in reality, the dollar is just a source of tradeoffs, and tradeoffs are a constant. Stocks have long since gotten used to all of this, even if headlines can’t get over it.