The dollar has figured prominently in the macro investing picture over the last two years, as it rose about 15% against a basket of trade-weighted currencies. In 2015 alone, the move up was 12%, the largest annual gain for the dollar since the 1970s. According to analyst Tony Sagami at Mauldin Economics, this has had a significant negative impact on S&P 500 (NYSEARCA:SPY) earnings. For example, the average American company experienced $0.12/share lower earnings in 3Q/2015 due to currency-related losses.
This has caused a certain degree of consternation in the markets, which when coupled with other negatives (such as falling oil prices, banking troubles, and a Chinese slowdown) has been a significant factor in the recent sell-off. Many analysts have projected a rising dollar for some time to come, which has had a very negative impact on many of the emerging markets, most of whom have heavy foreign debt obligations priced in dollars.
Of course, a higher dollar is generally not good for commodity prices, especially oil, so it is probably not a coincidence that the drop in oil prices occurred over the same time interval as the rise of the dollar.
But, looking ahead, there may be a different scenario played out than the consensus has priced in. As I have mentioned elsewhere, I don't think the dollar is going much higher. Recently, the dollar has fallen a bit from the high, suggesting a top is being formed. In fact, the conditions are probably now in place for a decline in the dollar that will surprise at least some investors. It is not too late to use this potential trend to your advantage though. If this dollar decline happens, there will be substantial positive changes in commodity prices and a potential strong short-term rally in the equity markets. So what are the conditions that might favor a falling dollar in the coming months? First, we can give the global economic slowdown some credit, because it appears to have given the Federal Reserve pause, and markets have completely repriced the risk (downwards) of further rate increases by the Fed this year, following the testimony of Fed Chair Yellen last week. This is automatically going to make the dollar weaker over the short run.
Second, the massive capital flows into U.S. Treasuries from many other countries with lower rates (such as Japan, Germany, Switzerland, etc.) will continue to drive U.S. bond yields down, thus decreasing interest rate differentials and favoring a weaker dollar over time. Indeed, recent TIC flow data indicate purchases of $51.8 billion in U.S. Treasuries in November, with much of that coming from Europe, where ZIRP and even NIRP have prevailed for some time.
Third, the U.S. deficit is increasing again, and is expected to rise from a massive $414 billion in 2016 to around $700 billion in 2020. This projected trend should tend to confirm the long-term decline in the dollar's value caused by ever increasing total government debt.
Assuming I'm right, what will be the effects of a falling dollar? We would likely see exports increase, which would favor U.S. industrial stocks (NYSEARCA:XLI). If the trend lasts very long, it might be associated with a falling P/E ratio, based on market history. We could also see U.S. small-cap stocks (NYSEARCA:IWM) outperform large caps in a falling dollar scenario, based again on market history.
A lower dollar would support higher commodity prices in general, and higher oil prices in particular, based on historical relationships. This would obviously favor energy (NYSEARCA:XLE) and mining (NYSEARCA:XLB) sector stocks.
One could also put in place a trade (NYSEARCA:UDN) to short the dollar, assuming the trend holds for a while (which is probably the case). The macro trend toward higher deficits and more total debt would support this trade in the longer term.
Disclosure: I am/we are long XOM, CVX, BP, EOG, TNH, WY, WLKP, EMN.
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