Between potential Fed rate hikes, a slowing global economy, and the relative strength of the United States economy the US-dollar index (DXY) looks poised to remain strong or get stronger this year. Of course this is a good thing if you have US dollar-denominated assets, but how is this going to affect the rest of the world and the financial markets? Here are the top 5 things to look for this year as the dollar continues to crush the world.
1. Oil and Commodities to Stay Low
Oil and other commodities are denominated in US dollars and therefore, have an inverse price relationship with the US dollar. A strong dollar is one of the many reasons oil prices continue to remain below $40 per barrel and look to remain that way for some time. Other key commodities like iron ore and copper also face negative outlooks which are partly derived from a strong US-dollar.
The longer DXY remains in the mid to high 90s, the more likelihood we will start to see default risk increase in the oil and commodity sectors worldwide.
2. Instability in Emerging Markets
Increased default risk in these sectors is not good for investors, but it's even worse for developing countries, many of which are reliant on commodity exports. Furthermore, some of the larger companies that pursue primary sector activities in these countries are State-owned. From China to Brazil to Malaysia to Saudi Arabia and Mexico, these nationalized companies and the accompanying governments are all facing lower revenues from depressed commodity prices.
We are starting to see the effects of this in Saudi Arabia where the government is slowly breaking the social contract as it cancels subsidies in order to balance an increasingly compromised budget.
The longer the dollar continues to squeeze commodity prices, and by extension emerging markets, the more precarious the situation will become overseas; increasing the chance of credit events that could rattle the markets.
3. Weaker Corporate Earnings
It's not just those companies outside the U.S. that are to be adversely affected. For the better part of a year, the number of S&P 500 (NYSEARCA:SPY) companies missing their earnings targets has been growing. In Q4 15, roughly 28% of S&P 500 companies missed earnings revenue, while nearly 48% missed revenue targets. The picture was even worse on the Russell 2000 (NYSEARCA:IWM), with almost 48% of companies missing earnings and 57.3% missing revenue targets.
Much of this weakness in corporate earnings can be attributed to the fact that American exports have become comparatively more expensive around the world, depressing demand for goods and services from the country's multinationals.
4. More M&A Activity
This is the one activity that seems to create more buy opportunities for investors. The dollar has been strong since 2014, when we started to see a large increase in global M&A activity as American companies got the cash-rich feeling that comes with a strong currency. But M&A isn't limited to American companies; there are plenty of foreign companies that have plenty of dollars to grow with.
Chinese companies in particular have been extremely active in the M&A space, with more than 100 global acquisitions announced already. Expect more to come as large Chinese real estate developers, flush with billions in dollar-denominated debt pursue global, diversified growth strategies.
5. Divergence Between Real Economy & Markets
Despite all the risks and data that suggest the real global economy is in decline, it is still quite possible for American equity markets to end the year higher than they opened. As headwinds continue to drag the world economy downwards, it's likely that more foreign investment will find its way into the markets and push indices up.
According to Wall St, this is the most likely scenario for the year: that US markets will end modestly higher while global markets and the real economy continues to falter.
Disclosure: I am/we are short SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.