Posted on April 9, 2015 by David Laidlaw
While the market for common stocks and bonds has been relatively stagnant this year, other markets are moving dramatically. In our commentary last quarter, we explored the phenomenon of lower energy prices and addressed the sudden collapse in oil prices. This quarter, our focus will be on the currency market.
Since April of last year, the Euro has depreciated by 22% against the dollar and the Japanese Yen has depreciated by 13% versus the dollar (see chart above). Most of the dollar’s strength appears to be a reflection of the weakness of the other major currencies and the actions of their central banks rather than the innate strength of the dollar. Both the Japanese and European economies have been growing extremely slowly. To stimulate their economies, the Bank of Japan and the European Central Bank have expanded their money supplies by quantitative easing and other techniques. Their goals are to lower borrowing costs and to weaken their currencies to make their exports more attractive, thus stimulating economic growth.
A strong currency benefits importers since prices for imported goods are lower than similar domestic products. This circumstance helps retailers such as Costco that buy clothes, appliances, electronics and other merchandise from abroad and then sell the majority of these items in the US. In its earnings release in March, Costco reported that revenue increased by 4.5% compared to the same quarter last year, while operating income jumped 21.1%. Income grew because operating margins expanded an impressive 0.4% from 2.8% to 3.2%, which is a very significant increase for a retailer. The company didn’t quantify the role that currency played, but it must have been substantial.
Similarly, dollar strength also helps US consumers. Imported goods are cheaper leaving more money in the budget for other items or savings. Now is the time to travel to Europe to benefit from lower lodging, meals and transportation costs.
On the other hand, a strong dollar weakens US exporters visa-vis their competitors. US goods and services become more expensive versus foreign alternatives. For example, the costs to produce Procter & Gamble’s shampoo in Germany becomes more expensive relative to Unilever’s products. PG will also earn less on that product when its European sales are translated into dollars from Euros.
These impacts are being reflected in lower corporate profits since roughly one-half of the sales of the companies in the S&P 500 are generated abroad. According to a March 22nd article in the Wall Street Journal, analysts expect S&P 500 profits to contract by 4.9% in the first quarter of the year and only grow 2.1% for the full year. Six months ago, the projections called for 9.5% growth in the first quarter and 11.6% growth for 2015.
Currency volatility makes corporate planning and all economic decision-making more difficult. People are generally risk averse and will tend to choose the safer course of action if they do not have confidence regarding future exchange rates. This uncertainty will continue to depress economic activity as long as the expectation of volatility persists.
Global interest rates are persistently low with certain banks now paying negative rates for deposits. During “normal” interest rate times, a depositor places his or her money with a bank and receives some fraction of the deposit back each year in interest. In a negative rate environment, the depositor pays the bank a percentage each period to hold the depositors money. For example, the German government now charges negative rates for bonds maturing within the next five years. The German 5-year note yields an astonishing -0.1%.
The persistence in interest rate differential between the US, on the one hand, and Europe and Japan, on the other hand, suggests that the dollar will remain strong. As of March 31, the 10-year US Treasury Note paid 1.93% while the German Bund yielded 0.16% and the Japanese Note yielded 0.40%. Therefore, US debt investors have been rewarded with higher rates and a strengthening currency.
The main central banks have been fairly coordinated in their efforts to stimulate the world’s economy since the financial crisis in 2008. There has also been a tolerance of Yen and Euro devaluation since those economic regions have been much slower to rebound from the global recession. However, there is nothing to suggest that this trend will continue. The Federal Reserve indicated that it may delay raising interest rates until September of this year even though the previous guidance suggested the rate hikes would start in June. If the strong dollar is no longer tolerated, competitive devaluations would produce greater instability.
The cold winter appears to have slowed the economy again similar to last year. Economists predict the US economy grew by 2.2% during the 1st Quarter; however, we would not be surprised by a lower print. Stock market gains have been very much against this backdrop. The S&P 500 gained 0.95% during the first quarter. Stocks are still expensive relative to historical averages and it appears that these currency headwinds will persist for a while.
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