During the second half of 2014, nervous investors were focused on the shifting economic fortunes caused by the swift 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 US 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 the long-awaited trip to Paris or Tokyo a lot more affordable for US residents, what are the ramifications of the dollar’s sharp rise in the financial markets?

First, let’s put the dollar’s recent rise in perspective.  While it is true that the Trade Weighted US 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 prospective, we do not believe the dollar is wildly overvalued.

The dollar’s rise has been driven by the diverging economic paths of the US (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 US 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 US cheaper.  The lower cost of imports to the US 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 US 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 US), thus boosting European economic growth.

As is the case with most macroeconomic variables, there are both positive and negative economic efforts from a strong currency.  The strong dollar is likely to reduce overseas demand for US exports, thus crimping the earnings prospects for US-based multinational companies.  That is the bad news.  On the plus side, low inflation is considered a positive for the US economy, in that it helps to keep interest rates down, stimulating demand for credit and investments.

The dollar’s ascent is likely to increase the appeal of US assets, particularly bonds, to international investors seeking a strong currency and high (relative) yields.  While US 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 economic doldrums.  We remain skeptical on that score.

Important Disclosures: 

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice.  This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements.  Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as the date of this document and are subject to change.

– Posted by Chris