The markets seemed to like what the Fed had to say yesterday, including the part about definitely, for sure, no kidding around this time raising interest rates in December. Especially elated were currency traders, who bid the US dollar up on the news.
Somewhat less enthusiastic, however, are the corporate executives who have seen their firms’ sales and earnings squeezed by a strong dollar of late. If rising rates make the dollar even stronger — as theory says they should — then presumably that makes corporate earnings even weaker. The media has been wrestling with various aspects of the dollar/corporate earnings/Fed policy connection for a while, and a consensus seems to be forming that there’s a conflict between aims and results in current monetary policy that another couple of months probably won’t resolve:
(Fox Business) – The strong U.S. dollar is once again emerging as a major theme this earnings season with Coca-Cola (KO) on Wednesday joining the ranks of other large multi-national companies that have seen their profits eroded overseas.
“I don’t think it’s going away anytime soon,” said Cliff Waldman, senior economist for the Manufacturers Alliance for Productivity and Innovation (MAPI), a public policy and economics research organization in Arlington, Virginia.
Wal-Mart (WMT) and Costco (COST), the number one and number two U.S. retailers respectively, have also told investors that the strong dollar is eating into their earnings. Wal-Mart said earlier this month that a combination of the strong dollar and wage increases for many of its employees could cut 2015 revenue by $15 billion.
The strong dollar is not a new issue for U.S. corporations: throughout 2015 an array of multi-national U.S. giants including Microsoft (MSFT), Monsanto (MON) and Caterpillar (CAT) have blamed the strong dollar after reporting disappointing earnings. According to a study by FactSet, 70% of the companies had cited the strong dollar as a negative impact on their 1Q earnings of 2015.
On Wednesday, Coke reported that its sales in Asia-Pacific fell 11% in the third quarter, while sales in Latin America dropped 14% and sales in Europe fell 7%. The three markets account for one-third of Coca-Cola’s total revenue.
Meanwhile, the US Dollar Index, which measures the U.S. currency against a basket of six global currencies, has risen by about 15% in the past 12 months.
The problem for these big multinationals occurs when their profits generated in weakened currencies such as the Euro or the Brazilian real are brought back to the U.S. and exchanged for the stronger U.S. dollar. The strong U.S. dollar also makes it more expensive to sell U.S. exports overseas, which benefits the international competitors of U.S. companies.
“It’s a very difficult situation for U.S. manufacturers,” said Waldman.
This puts the ball back in the Fed’s court as it has to weigh the impact on the dollar of any decision to start normalizing rates even if it tries to downplay the impact of the exchange rate.
Think about it. A rate liftoff or even expectations that it will start sooner rather than later would increase the value of the dollar. A firmer dollar, in turn, would weigh on commodities, especially crude oil. This would increase global concerns (e.g. emerging markets) and dampen US inflation expectations, making it harder for the Fed to achieve its 2% target. It would also increase concerns over an already struggling manufacturing sector where the dollar continues to be cited as a headwind on earnings.
So, the Fed is caught in the currency war after Draghi undercut the EUR and weakened it vs. the dollar, removing what would have been a cushion (i.e. weaker dollar) that would have made it easier for the Fed to consider a liftoff. Now, with the dollar back on a firmer footing, the Fed has less leeway to speed up liftoff without sending the currency higher as technicals have moved back in its favor.
Let’s assume that the Fed, after all its dithering, feels honor-bound to raise rates even in the face of slowing GDP growth and increasing global tensions. The dollar will almost certainly respond by rising or at least remaining stable at its current high level.
This in turn means that corporations will face continued pressure on sales and profits, and that the earnings recession will continue for at least another year before easy comparisons start making it possible to “grow” again.
What does that mean for the equity markets? Has there ever been an ongoing rise in share prices when corporate earnings were in a multi-year decline? That’s not rhetorical. Market historians, feel free to weigh in here.