The Japanese economy has been undergoing shock treatment to awaken it from a deflationary slump. A major part of this program is the devaluation of the yen, which has fallen 21% relative to the dollar since the end of the third quarter of 2012. The economy is indeed showing signs of life with the Nikkei 225 Index up 54%. Despite recent volatility, the Japanese stock market still outperformed all other developed markets in the first half of 2013.
With the U.S. economy in only a tepid recovery, should policymakers turn Japanese by depreciating the dollar to juice our manufacturing base and exports? Few stimulus options remain with interest rates still near zero and high debts restraining federal spending. For Obama to meet his 2010 promise to double exports by the end of 2014, he'll need far more than his faltering trade deal with the EU.
On the surface, devaluing the dollar seems attractive with inflation below the Fed's target. Out of those companies in the S&P 500 Index that report foreign sales, almost half of revenue comes from another country. So a cheaper dollar would boost exports while also increasing the dollar value of foreign assets. Consider just cash. Excluding financials, publicly traded companies have over $800 billion outside the U.S.
But the stock market provides less than mediocre returns when the dollar declines relative to the currencies of our major trading partners. The dollar started floating in 1971. Over the last 40 years since the Federal Reserve created an index of the dollar's value, the U.S. market returned less than 6% when the dollar trended down but almost 15% when the dollar was appreciating. Two of the best ways to play a uptrend in the U.S. market are the SPDR S&P 500 ETF (SPY) and the iShares Core S&P 500 ETF (IVV).
The stock market's reaction to exchange rates depends largely on the central bank. When the dollar depreciated while the Fed was lowering interest rates (loose monetary policy), U.S. stocks returned around 14% compared to the 40-year average of 10%. This economic situation is currently what is happening in Japan. The Bank of Japan plans to increase its money supply by over $600 billion a year. So the recent outperformance of Japan's stock market is actually consistent with the U.S. experience.
The trouble starts when these policies inevitably lead to higher inflation and interest rates. Then the central bank has to tighten monetary policy and economic growth slumps. The U.S. stock market has fallen over 3% per year when the dollar declined during tight monetary policy.
This combination produced one of the most traumatic events in our financial history; recall October 1987. The Federal Reserve uncovered a powder keg in September by hiking the discount rate and ending three years of loose monetary policy. Treasury Secretary James Baker added the spark with threats to devalue the dollar to combat our trade deficit. The explosion occurred the next week with a 22% plunge in the stock market on Black Monday.
With the Federal Reserve soon to be tapering Quantitative Easing and normalizing interest rates, now is the worst time to pursue a depreciation in our currency as Japan as done. The good news is that the dollar has been relatively stable over the last five years with the value relative to major trading partners about 10% above its low in 2008. It's tempting to want to want to maintain trade competitiveness with other countries but it's not worth the risk to our recovering financial markets.
Our currency has a high value as a safe haven while European unemployment creeps ever higher and emerging markets are in turmoil. Let's keep it that way or risk another Black Monday.
What industries should investors over/underweight if the dollar stays strong while the Fed is tightening? During such periods over the past 40 years, the financial industry provided the highest total returns (19.9%/year). Financials tend to benefit from higher loan demand and lower default rates. Also, banks will benefit from better net-interest margins as interest rates return to normal levels and the yield curve steepens. The Financial Select Sector SPDR ETF (XLF) provides exposure to the financial stocks in the S&P 500 and is one of the best ways to overweight this sector. The iShares U.S. Financial ETF (IYF) is another good choice.
Consumer goods companies outperform when the Fed is loosening and inducing consumers to spend more. Stocks in the consumer goods industry have the worst record (-1.8%/year) when the dollar and interest rates have trended up as we are seeing in the current environment. Reduce exposure to this sector and reevaluate positions in such ETFs as the Consumer Discretionary SPDR (XLY) and the iShares U.S. Consumer Goods ETF (IYK).
For a detailed study of how exchange rates affect equity prices, see this research: Stock Returns and the U.S. Dollar: The Importance of Monetary Policy