09.28.2022 Market risk-takers are grappling with the double-barreled threat of persistent dollar strength and dramatically higher interest rates. Equity investors fear that a stronger dollar could ding earnings growth while higher interest rates could compress multiples. Both factors are largely responsible for today’s equity bear market. Unfortunately, surging inflation is the malady, harsh central bank tightening is the treatment – and we’re only just beginning to feel the side effects.
Economic activity has declined sharply in Europe, raising the risk of recession as governments face higher prices and weaker economic conditions. The UK pound slipped to its lowest level against the dollar since 1985 after the Liz Truss government proposed tax cuts to restart growth. Investors worry that such fiscal easing could fan the inflation flames in the UK, where retail prices have surged more than 12 per cent over the last 12 months. Retail sales in Europe have cratered in recent weeks, weighed down by the lowest consumer sentiment readings since records began in 1985, according to The Wall Street Journal. The Euro, having fallen through parity a few weeks ago, sits at its weakest level against the US dollar since 2002. Trade volumes are sputtering. South Korea’s semiconductor exports have slipped to their lowest level in over a decade. Despite the weakest Japanese Yen vs the dollar since 1998, Japan’s trade balance has fallen sharply as well.
Here at home, economists are marking down their growth forecasts as well. Thankfully, however, the US economy is somewhat insulated because global investors continue to view the United States and its currency as safe havens despite hot price growth. A survey of private economists conducted by Bloomberg shows US growth, while positive, won’t exceed 1.5 per cent through the end of next year. Still, against the backdrop of energy shortages in Europe and double-digit inflation in the UK, our tepid growth is a balm by comparison. Consumer spending and the job market remain robust and some European multinationals, including Germany’s BASF, are shifting production to the US and its abundant natural gas supplies.
The dollar, up nearly 20 per cent against a broad basket of currencies, has surged to its highest level in 20 years. While this surge will attenuate price inflation, particularly among commodities, dollar strength carries other risks, particularly on the earnings front. Dollar strength hurts both top and bottom lines by discounting the value of foreign revenue and by making US goods and services more expensive on the world stage. Company managements have pointed their fingers at dollar strength as the source of their revenue and profit shortfalls. Salesforce Inc. projected foreign currency translation will cost it $800 million in full year revenue in 2022, according to Bloomberg. Proctor & Gamble expects a $900 million after-tax hit this fiscal year as well.
We believe the dollar will peak and roll over once investors anticipate light at the end of the Federal Reserve’s tightening tunnel, which we expect to occur sometime before the end of this year. In the meantime, the dollar has exhibited powerful momentum, risking near-term dislocations. The dollar’s 50-day moving average is trading well above its 200-day moving average. History suggests that the 50-day would need to fall below the 200-day to suggest a significant momentum shift. Until that happens, we remain in a “risk-off” environment.