If the U.S. economy remains as it is - that is creating jobs without any wages - the strengthening of the U.S. dollar might falter, or even reverse. I would not change my call for a Fed tightening this summer, hence my assumption for a strong dollar head on. Among the widely discussed subjects so far this year, the potential impact of a stronger USD on corporate earnings is on top of the list.
There is no straightforward ex ante impact of a stronger USD on earnings (I take 12-month forwards earning per share or EPS). A stronger currency can indeed reduce the USD-denominated revenues generated abroad through a pure valuation effect or the volume exported as price-competition is heightened. On the liability side though, a stronger currency means lower (imported) input costs and higher margins if the mark-up is not changed.
I run a model for the broad U.S. economy, trying to figure out if there is any statistical link between EPS forwards and the USD. The model is based on several inputs.
i. Level of capacity utilization. Earnings tends to increase when the capacity utilization rate is high. There are many explanations for that
a. A high level of capacity utilization means that aggregate demand is strong;
b. It suggests also that business have more leeway to rise their selling price;
c. It also drive investment higher. There is a strong link between investment and the absolute valuation of stocks, as can be seen in the chart below.
ii. The slope of the yield curve. A steeper yield curve should be positive on earnings since:
a. It suggests that the expected short terms rates are due to rise, hence that the economic activity is solid;
b. From a sectorial point of view, it enhances the profitability of lenders/banks. This effect may have weakened though since:
i. The financing of the economy is less and less dependent on banks (corporate bond issuance, shadow banking);
ii. The reading of the signals sent by the slope of the yield curve have been blurred by the "conundrum" and the successive waves of quantitative easing.
iii. Global trade. This is a no brainer. When the global economy is strong, global trade is soaring, and earnings are growing. Interestingly enough, the commodity cycle is highly correlated to the world trade. For that reason, I don't include any commodity price in my model (double counting).
iv. U.S. Dollar. On top of the impacts listed above, the U.S. dollar might also be an indicator of portfolio flows towards emerging countries and hence their relative economic performance. As can be seen below, a strong USD comes generally along with an outperformance of US stocks against the MSCI world, a sign of weakness in the EM world.
The results of the econometric analysis are provided in the table below (first column). All factors have the expected sign and are significant but one: the U.S. dollar. Not only is the dollar statistically non-significant but the only time it did become significant in my stability tests (a way to gauge how the sign and significance of the USD change as time passes by), the sign came out positive!
A rapid conclusion from this is that the USD is not a factor that significant alter the broad yearly change of forward EPS. Does it play a role on a micro scale? To test this I run the same model on a sectorial basis. Results are shown in the right section of the table above. The dollar is only statistically significant for Industrials, Utilities (positive impact on earnings), Telecom and Materials (negative impact on earnings).
In other findings, global trade has a strong positive and statistically significant relationship with forward earnings growth, both at the overall market aggregate level, and at a sector level. The slope of the yield curve is supportive for financials, which confirms the ex-ante expectations described above.
I do not find a strong statistical link between the dollar and S&P500 forward earnings growth but there appears to be one on several sectors: during the sample covered, dollar strength had a statistically significant positive impact on earnings for Industrials and a negative impact on Materials. I built a long/short index of Industrials versus Materials. The chart below plots the 6m excess return of this index relative to the USD. The relationship between the two has generally been positive.
Bottom Line: The message is clearly that the impact of the US Dollar on forward EPS growth is far from straightforward. It may have some sectorial impact. Interestingly enough, the conclusion in terms of relative performance of sectors is decent albeit not overwhelming.
A similar analysis of the impact of dollar appreciation on past returns instead of forward EPS shows that the dollar is also statistically non-significant for S&P500 returns on aggregate (table below). Looking at sectors, dollar strength has a negative impact on Materials and a positive impact on Industrials, Financials and Consumer Discretionary sectors.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.