"Democracy," Winston Churchill famously observed, "is the worst form of government except all the others." The dollar, long situated among the worst currencies, has suddenly become the best among the worst.
Investors assume a strong dollar is a negative for the earnings of the U.S. multinationals in the S&P 500, because these companies derive over 40% of their earnings in foreign markets. Backing out the 15-20% of S&P companies that largely derive their earnings in the U.S. (mainly banks, utilities, and some consumer discretionary companies leveraged to homebuilding), we see that foreign-exposed countries may have up to 50% of their income coming from overseas. But, as we argue below, we think the so-called trade-weighted benchmarks may be overweighting currencies of some of our legacy trading partners while underweighting the currencies where U.S. multinationals are actually doing business.
To see what the dollar is up to, we used the Bloomberg U.S. Dollar Index, which tracks the performance of a basket of 10 leading currencies versus the U.S. Dollar. The weight of each currency in the index is rebalanced annually based on share of international trade and FX liquidity. In 2013, the largest currency weight in the basket, no surprise, is the Euro, with a 34.3% weight. The Japanese Yen has a 16.2% weight; the Canadian Dollar, just under 12%. The Mexican Peso and Great Britain Pound are in the 8%-10% range. The final five currencies - the Australian Dollar, Swiss Franc, Singapore Dollar, Korean Won, and Chinese Yuan (Renminbi) - range from 3% to 6% each.
We charted this index, BBDXY, back to the beginning of 2009 to see how it has fared during the bull market and the age of quantitative easing. The BBDXY hit its peak price on 3/9/09 - precisely the day the S&P 500 hit its lowest level since 1966. It is hard to fully recapture the panic in fall 2008 and winter 2009, when dollar strength had nothing to do with U.S. fiscal solvency and everything to do with the Armageddon feeling besetting most of the financial world. On that day, when the BBDXY index was at 1,144.125, the dollar was still viewed as the last lifeboat in an ocean of financial wreckage.
As the global banking and monetary system began to stabilize, the BBDXY index slid to the 975 range late in 2009, rebounded to the 1,100 area in April 2010, and then began an extended slide lower. BBDXY hit bottom in March 2011 and followed with a confirming twin bottom at a slightly lower low of 912.58 on 7/26/11. That low occurred as the clock ticked ever closer to the Debt-Ceiling Expiration, whose imperfect compromise would send the S&P 500 crashing 18% lower in late July and early August.
From early 2009 to mid-2011, the dollar slid down in a series of lower highs and lower lows. During this time, quantitative easing went from a novelty, to policy, to an addictive substance for many investors. The BBDXY has since worked quietly upwards in a reverse pattern of higher highs and higher lows. The BBDXY index, above 1,000 in summer 2012, slid back to the 970s as the Presidential election heated up and the tax-cut expirations neared. BBDXY rebounded off the tax settlement and sequester and has recently made 2-1/2 year highs in the 1,015 area.
Although QE is still in place, the post-QE future is now being discussed. The tax settlement and sequester are modest first steps toward solvency. But these domestic factors do now fully explain the dollar's recovery. On balance, the dollar should still be weak, given our policy. But everyone else's policy is worse.
The biggest currency belly-flop in 2013 to date is the yen. For decades, Japan did all the right things in living within its means, and was rewarded with a strong currency - a disastrous development for an export-driven economy coping with the rising export might of China. Japan has adopted our quantitative easing, but in a dangerously compacted, "all at once" program with unforeseeable consequences. The yen has plunged 20% against the dollar just since November 2012 (as of mid-April 2013). The UK is the other single currency most responsible for evident dollar strength
Other currencies are being similarly battered as governments seek to calibrate between monetary ease and austerity. Great Britain may have too much austerity. The dollars of Canada and Australia, strengthened by China's appetite for natural resources, have declined with commodity prices. The up-and-down euro is in a declining trend once again amid signs that Europe cannot escape its persistent, low-grade recession.
Both within the BBDXY and without, a handful of currencies remain strong against the dollar. These include several emerging market currencies, such as Singapore dollar, the Mexican Peso, and China's Renminbi. A handful of Northern European currencies, such as the Swedish kroner, have also remained strong.
Dollar strength, so unfamiliar in the QE era, must now be reckoned with in earnings season. When the dollar is strong, goods made here are expensive to sell in weak-currency markets; product prices themselves are too high and uncompetitive in weak-currency markets; and revenues generated in weak-currency markets are repatriated at unfavorable rates.
But will the impact on EPS be as severe as the movement in the trade-weighted currency basket would suggest? We think not. Let's return to those Bloomberg currency weights and run them against U.S. Census data on total trade for the year 2012.
The Euro is accorded a 34.3% weight in the trade-weighted basket. Yet our four largest European trading partners - Germany, France, Netherlands, and Italy - together represent 9% of U.S. total trade in 2012. While remaining Euro Zone members may add as much as nine points more in aggregate (we estimate it is closer to seven points), that still sums to a mid-teens contribution to our trade - well below the one-third weighting used in most trade-weighted baskets.
The Japanese yen has a 16% weight in the basket, while the Great Britain Pound has a 9% weight. Yet 2012 census data suggests that Japan accounted for 5.7% of our total 2012 trade, while Great Britain was 2.9%. These two nations cumulatively comprise 25% of the dollar-weighted currency index, even though trade with the two nations sums to less than 9% of total.
If we are not trading as much with those legacy partners, with whom are we trading? Our largest trading partner, Canada - at 16% of 2012 total trade - experienced several years in which the loon strengthened against the dollar along with resources prices. That trend has reversed. The 200-day moving average in this relationship is parity (U.S. $1.00 = C $1.00). The exchange rate has moved a few percentage points off that trendline in recent months, but the rate of change is in low single-digit percentages.
Our second and third-largest trading partners are China, at 14% of total trade, and Mexico, at 13% of total trade. China and Mexico summed to 27% of total trade in 2007. In recent years, the Chinese Renminbi has strengthened vs. the dollar. But the Chinese currency has not been as strong as the Mexican Peso, which is benefiting from its destination status as North America's low-cost manufacturing hub, as well as the southward migration of U.S. retirees
U.S. multinationals are old hands are hedging currency risk, but most were not sufficiently hedged for the severe trend change in yen since fall 2012. The good news pertaining to EPS growth is that yen risk - much like euro risk and pound risk - is overstated in traditional trade-weighted dollar movements.