Periods of sustained dollar strength and increased volatility can have very important implications for corporations and investors. Strategic and tactical decisions, earnings growth, and cash flows at corporations can all be greatly influenced by the swift rise of the dollar. Increased uncertainty and heightened volatility can also impact the relative earnings prospects of publicly traded companies and, therefore, their share prices.

With regard to corporations, there are positives and negatives to a stronger dollar. A rising dollar signals that the U.S. economy is expanding more rapidly than the economies of other countries, which helps corporate revenue growth. For companies that import raw materials, or goods and services, a stronger dollar means lower import costs, which enhances their profit outlook.

Lower import prices also help reduce inflation, which should increase real wages for individuals who can thus spend more, creating a virtuous cycle of a stronger consumer. Lastly, approximately 63% of revenues – a reasonable proxy for earnings – of S&P 500 companies are domestically generated. We expect this will exert a positive upward bias for overall earnings.

 On the negative side, a rising dollar means that sales made by U.S.-based companies in foreign countries translate back into fewer dollars, creating foreign exchange headwinds. We estimate that approximately 37% of revenues for companies in the S&P 500 are generated overseas, and, for every 10% rise in the U.S. dollar, EPS is negatively impacted by 4%. Companies also face balance sheet issues as they manage receivables, payables, and inventories, which can put pressure on margins.

We believe that these challenges will be particularly pronounced during the first- and second-quarter earnings season of 2015, as the dollar (as of 3/31/15) has risen 23% compared to the end of March and June of 2014.

Higher Domestic Revenues a Plus

 Although all of these factors increase the difficulty of picking stocks that can outperform the market, we believe that there is a clear strategy to choosing those companies likely to benefit most from an appreciating U.S. dollar. The companies likely to benefit the most are those with a higher percentage of revenues from the U.S. Some industries and companies will gain more than others from lower import prices and inflation. Certain industries, including technology, industrials, staples, and materials, have higher than average exposure to international markets, and therefore to currency headwinds. The energy sector not only has a high percentage of overseas revenues, but oil is priced in dollars – meaning that the higher the dollar goes, the more expensive it is to purchase oil, which impacts demand.

Nonetheless, we believe that there are companies within these industries that can do well, especially if revenue growth and asset turns are high enough to offset headwinds created by the stronger dollar.

Investors also need to consider the impact that a stronger dollar has on valuations. Our research indicates that there is an 81% correlation of a rising dollar to higher price-to-earnings ratio (P/E ratio) multiples for the companies that compose the S&P 500 Index. According to this, the higher the dollar, the higher multiples should go. The sensitivity is such that every 10% rise in the dollar raises the S&P 500’s P/E ratio multiple by 2. Given a P/E ratio of 17x, this increase of 2 is the equivalent of a 12% rise in earnings, which would likely counterbalance the negative 4% earnings per share decrease described earlier.

The bottom line is that while market volatility is likely to rise as the stronger dollar impacts industries and companies in various ways, especially in the short term, the benefits to the domestic economy appear greater than the negatives. The resulting boost to earnings, combined with higher multiples, should bode well for stock prices as we sail through choppy seas.

The Fed’s Impact on Foreign Currencies

The U.S. dollar has been on a tear, rallying 23% since last June. Since the financial crisis of 2007 to 2009, the foreign exchange markets have been unleashing a great deal of volatility, especially as each country has deployed varying degrees of changes to monetary and fiscal policy in an attempt to improve its economic growth.

The recent rise in the trade-weighted dollar (a basket of currencies weighted by the amount of international trade) places the dollar at its highest level in 12 years. We believe there are two primary reasons for this increase: first, the pickup of strength in the U.S. economy, which has attracted global investors looking for investment opportunities, and second, speculation that the Federal Reserve Bank is preparing to increase overnight interest rates from the record low range of 0.0% to 0.25%. This rate increase would be a stark divergence from many of the world’s other central banks, which are lowering interest rates at this time.

The Fed cannot control the global flows of the dollar, for that market is much too large. Furthermore, the Fed is not responsible for the policy of the greenback, which is a function of the U.S. Treasury (keep in mind, though, that the Fed does carry out the foreign exchange trading operations for the Treasury Department).

With that being said, the Fed’s monetary policy decisions can affect the value of the dollar, which can affect the domestic economy. As we have witnessed since mid-2014, as the Fed has planned for higher overnight rates, the dollar has rallied, thereby placing downward pressure on inflation due to cheaper imports. This has helped to reduce exports, due to the higher costs for international buyers, which in turn has served to undermine domestic manufacturing strength. Once the Fed acts upon these planned rate increases, it may exacerbate the situation further.

It is important to remember that the appreciation of the dollar, we believe, is occurring for the right reason: it is a result of stronger U.S. growth. This is important to understand, because if the dollar were rallying due to a flight to quality – which means weak global confidence and weak capital markets – then the implication of the actions of the Federal Reserve would likely be much different.

The stronger dollar is a stimulant for much of the global economy, which has encountered tepid to waning growth. In Europe, monetary policy is helping to weaken the value of the euro to stimulate the economy. As a result, exports will likely be cheaper, and the industrialized north will likely benefit. Tourism should get a strong boost, and this should benefit the south. Overall, other exporting countries around the world should also benefit as their products become cheaper for American consumers.

Domestically, which is the focus of the Fed, the strong dollar will help put downward pressure on inflation and exert a drag on exports. This runs counter to the Fed’s expressed goal of an inflation rate of about 2% – inflation, as measured by the Core Personal Consumption Expenditures Price Index, has been below the Fed’s target for almost three years now – and higher rates would increase that downward pressure. After a long period at low levels, expectations for inflation begin to be backward-looking. This tends to drag inflation even lower, which may delay the onset of the Fed tightening. In regard to exports, even though the U.S. is a relatively closed economy and exports make up just 13% of GDP, the downward pressure on exports will still likely dampen economic growth. An even bigger issue lies with large multinational companies, as their overseas profits will be restrained, possibly leading to reduced earnings.

At this point, the Fed is cognizant of all the global and domestic issues that will be affected by its monetary policy choices, as well as the effect on the value of the dollar. Forefront in the Fed’s decision making is to ensure that its actions do not create uncertainty and volatility that may disable the U.S. economy.

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 Kelly