The Long View – Should the weak dollar scare you?
Juggling the impacts on trade, growth and inflation
A weak dollar has a positive impact on trade (for the US), which can provide a big boost to American GDP growth.
President Trump loves to boast about the stock market and, if the weak dollar leads to even stronger share prices, then his administration might let a weak dollar policy continue.
Dollar still bearish after recent Dow drop
Global stock markets did have a significant decline in early February but this is largely seen as a healthy correction after a very steep rise. Nothing has changed fundamentally to signal an extended stock market rout.
So while the dollar rebounded briefly as US bond yields spiked, it is important to note that those bond yields are already near the 3% level (for the 10-year) that most forecasters expect for the rest of 2018.
China’s reaction can bring volatility
The main target of this policy is China and a lot depends on China’s response. If China offers no resistance, then stocks and other risk assets may continue to perform well.
However, if China responds aggressively, this could punish nearby emerging markets (EM) and, if China retaliates by selling US Treasuries, also punish the US bond market and hamper growth.
There would also be a modest inflation impact to be watched carefully: a weaker dollar has a significant negative correlation with oil and other commodities (they tend to rise when the dollar weakens) – this could decrease disposable income for the average American.
As foreign imports become more expensive, US inflation could rise more rapidly than expected and this too could hurt bonds and raise interest rates, effectively slowing the economy.
Which stocks could gain? And lose?
For some US stocks, the weak dollar is a blessing. Many big name US stocks are directly linked to oil and other commodities.
The commodity price rebound in the last two years has led to major upward earnings estimate revisions from stock analysts.
Some of these big US companies could further benefit if they report earnings in US dollars but collect some, or most of their, earnings from outside the US in stronger currencies.
On the other hand, some non-US companies could report disappointing earnings because of the weak dollar.
Companies in Europe and EM countries where currencies are appreciating will be hurt if they report their earnings in their local currencies but also have operations in the US or dollar-based countries that generate income in US dollars.
Furthermore, companies in EM countries also need to be careful about dollar movements, as many of them issue debt in US dollars.
In this case, however, the problem is when the dollar strengthens, and debt servicing becomes an issue for companies that did not hedge their dollar exposure.
Consequently, a weaker dollar is positive, as it means it is easier for them to service their debts.
Decrease exposure to Asian stocks?
A weak dollar is clearly a threat to Asia, in particular, because the region is so heavily dependent on trade.
With a weaker dollar, Asian exports would become less competitive.
Not only will the price of their exports be less appealing, but also their US dollar earnings will be worth less in their home currencies.
China has the firepower to put up a currency fight with the US, but other Asian countries can do little more than try to soften the blow by tinkering with monetary and fiscal policy, as well as boosting productivity and innovation.
What if a weak dollar goes too far? “Sell America”?
ING Bank pointed out in a late January report that there was a precedent set in the early 1990s when President Clinton and his Treasury Secretary Lloyd Bentsen targeted a weaker dollar to tackle the trade deficit with Japan.
The policy spiralled out of control and unintentionally resulted in the selling of US Treasuries, a weak period for US stocks — consequently a “Sell America” sentiment prevailed.
A “Sell America” period of lower stocks, lower bonds (higher yields) and a persistently lower dollar is not quite here yet but could be the result if the Trump’s administration ratchets up its “America First” ideology with more protectionist policies.
Were we already heading for a bear market anyway?
Société Générale notes that the rebound in commodities prices has overshadowed what is actually a rather bleak picture for stocks.
When we exclude the energy sector, it appears that the growth in cash flow (net operating cash flow) has decreased from 7% to just below 3%.
This sub-3% level is often associated with periods of weak economic growth.
This declining cash flow is actually happening at the same time as revenues and net income are increasing.
However, in the analyst world, “Cash is King” and the worsening cash flow, combined with the current flattening yield curve (which typically occurs prior to a recession), could be a warning sign for stock markets.
As we see from the above, there are plenty of opportunities and risks that come with a weak dollar policy.
However, it is clear that President Trump has prioritised stock market performance and jobs creation.
A brief stock market correction, like the recent 1000 point Dow index drop, is unlikely to change the current or medium-term dollar strategy for the President and his team.
Therefore, we think it likely that President Trump will direct his dollar policy towards keeping the stock market and jobs numbers on paths that makes him look as good as possible.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.
