The strong dollar has made headlines in recent months, but is it something to cheer about if you're an equities investor?
Sure, if you're a vacationing American in Paris or Tokyo. But if you put on your investing hat, you may want to hold the applause and ponder the effects of a strong dollar on U.S. businesses.
A Brief Currency Primer
In addition to the U.S. dollar (USD), other major currencies include the EU's euro (EUR), British Pound (GBP), and Japanese yen (JPY). The U.S. dollar is described as strong, appreciating, or rallying, when its value and strength has risen relative to these and other currencies. In this case, it has gained value compared to another currency with more purchasing power than before.
A weak dollar simply means the U.S. greenback has fallen in value and you cannot use it to purchase as much of another currency as before. Other ways of describing a weak dollar are "depreciating" and "declining."
The below chart illustrates this trend of a weaker euro and a stronger dollar. It used to take almost $1.40 to buy 1 euro. Now it only takes roughly $1.1 to buy 1 euro due to the depreciating euro, caused by various debt and contagion concerns in the region such as the Greek crisis.
Who Benefits from a Strong Dollar?
Let's walk through how a strong dollar affects different pockets of the economy.
Consumer spending. With about 70 percent of U.S. gross domestic product (GDP) comprised of consumer spending, our economy is incredibly reliant on active consumption.1
Accordingly, a stronger dollar should increase consumption given the rise in purchasing power. When prices of goods go down, your disposable income increases and overall consumption tends to rise. As Americans spend more money on things like food, apparel, and entertainment, consumer staples and consumer discretionary categories should do well.
Imports. Goods made in other countries become cheaper as the dollar commands greater purchasing power. This means Asian imports such as electronics and luxury cars from Europe start to look more affordable to U.S. consumers. In addition, since overseas demand for U.S.-made goods tend to decline when the dollar is strong, manufacturers may cut their prices to get rid of any excess supply, shrinking their profits.
Tourism. A strong dollar may spur more of us to go abroad while fewer overseas tourists come to us. Depending on the destinations they service, some airlines, cruise lines and hotels may benefit.
Manufacturing. A rising dollar can have a negative impact on U.S. manufacturers and commodities that have international rivals. American companies can have trouble competing if weakening foreign currencies sap overseas demand for their products.
On the flip side, U.S. industrial firms such as Caterpillar Inc. (NYSE:CAT) that import a lot of equipment and machinery but sell domestically may benefit from a strong dollar. A decrease in input costs and a rise in consumer demand mean higher profits.
Multinational corporations. U.S. companies such as Apple, Inc. (NASDAQ:AAPL), McDonald's (NYSE:MCD) and Coca-Cola Enterprises (NYSE:CCE) that have sizable overseas markets may see softening international sales when the dollar is strong. Meanwhile, foreign multinationals deriving a large portion of sales from the U.S. often win in a strong dollar environment.
Real estate. A strengthening dollar may lure foreigners to invest in U.S. real estate. Not only can these investors profit from the appreciation of the underlying property due to strong local fundamentals, they also stand to gain from the strengthening dollar because the properties are denominated in dollars. Likewise, Americans may put their dollars abroad when the dollar buys more. Among the countries that have seen significant currency depreciation are Canada, Malaysia, and Brazil.2
U.S. Treasuries. Overseas investors are generally more attracted to U.S. Treasuries and other U.S. fixed-income securities when the dollar is strong. A strong dollar signals our economy is stronger relative to that of our peers. China and Japan are the largest buyers of U.S. debt, partly because they are also two of our largest trading partners. If interest rates are expected to rise in the U.S., then U.S. Treasury interest from foreigners may wane, as principal values will decline.3
Emerging Markets. A continuously appreciating dollar can cause emerging market currencies to spiral downward. Governments and businesses in emerging market countries can face rising dollar-denominated liabilities that can make it difficult to meet their obligations. As the global economy becomes more interconnected, what affects one country often spill over borders.
You may remember the Asian financial crisis that began in mid-1997 and led Thailand to stop pegging its currency to the U.S. dollar. Shortly after, currencies of South East Asian countries - Malaysia, Indonesia and the Philippines - started to depreciate sharply. Regional stock markets declined, shaking investor confidence globally.4
Keep an Eye On The Dollar
Now that you know why you need to monitor the dollar, a helpful index to watch is the U.S. Dollar Index (DXY, USDX). This index measures the value of the dollar relative to six major currencies: the euro, British pound, Swedish krona, Swiss franc, Japanese yen, and Canadian dollar. The USDX began in 1973 with a base of 100 and is tracked relative to that base.5
Another good follow through may be to identify the companies behind the stocks or motifs you own that derive a big chunk of their sales from overseas markets so you can be prepared to act if the dollar grows more muscle.
- Torry, Harriet, "Economists React To Fourth Quarter U.S. Growth: 'Consumer Spending And Housing Remain Solid,'" The Wall Street Journal, January 29, 2016.
- Scotiabank, "Foreign Exchange Outlook, "Scotiabank, March 2016.
- Department Of The Treasury/Federal Reserve Board, "Major Foreign Holders Of Treasury Securities," U.S. Department Of The Treasury, February 16, 2016.
- PBS, "The Crash: Timeline Of The Panic," PBS, 2016.
- Marotta, David John, "What Is The US Dollar Index," Forbes, January 17, 2015.