U.S. Dollar's Rise Has a Dark Side - Merrill

Includes: UDN, UUP
by: FP Trading Desk

Investors in the U.S. have responded positively to a firmer U.S. dollar, says Merrill Lynch North American economist David Rosenberg, but there is a darker side to the story.

Mr. Rosenberg said in a research note that the rising dollar has likely had an impact on commodity markets and the recent drop in oil prices, a situation that investors have welcomed. “There is no doubt that the decline in oil prices is good news from a margin-supporting standpoint, as well as helping put at least a tentative floor under consumer confidence levels,” he said.  Mr. Rosenberg added that a decline in commodity prices and a stable–to-firm U.S. currency are bright developments – especially since they have contributed to lower inflation expectations.

However, he noted that one of the main reasons for the rise in the U.S. dollar is that economic conditions outside the U.S. have been deteriorating, with real GDP contracting in Japan, Germany, France, Italy and Hong Kong.  “We also know that Canadian GDP contracted in the first quarter with little bounce in the second quarter.”

The economist noted, though, that the share of U.S. corporate profits dependent on the dollar and domestic demand overseas recently hit an all-time high of 25%. “This heavy reliance on the global economy, in turn, leaves the earnings outlook more vulnerable to shifts in economic conditions than ever before.”

It is conceivable, he added, that a global slowdown could see the foreign segment of U.S. profits decline by as much as 20% year-over-year. And with no clear indication that the U.S. housing and financials markets have bottomed in the U.S., "it’s a possibility that corporate profits could decline another 25-30% from here.”

“This isn’t our forecast, but we believe it is conceivable – and much more likely that the current consensus forecast of an increase of 23% for S&P 500 earnings.”

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