Every period of time when the US showed the strongest economic growth was accompanied by 3 things: rising or elevated yields, a rallying stock market and a strong US Dollar.
And while a strong US Dollar is one leg of the “strong US economic growth” stool, 2 things are important to understand. First, just like in the movies and the standard good cop-bad cop routine, a strong US Dollar can either be a “good” USD rally or a “bad” USD rally. Second, a strong USD isn’t necessarily beneficial to everyone.
When it comes to good USD versus bad USD it all comes down to what’s driving the rally. A good USD rally is driven by strong economic performance, on an absolute or relative basis, and accompanying monetary policy. This type of rally is also orderly in its magnitude and duration.
On the other hand, a bad USD rally is driven by a loss of investor confidence caused either by higher volatility or growing global uncertainty, or both. Instead of being orderly, this type of USD rally travels higher and faster, potentially leaving a ton of wreckage in its wake.
Before I dive in further, let me make a disclaimer.
It is very dangerous to use historical data to make assumptions about the future. The global economy is complex and really about human action, which makes it highly subjective and near impossible to reduce to data points.
It's flat out inaccurate to say that the USD was strong over some period of time and over that same time period Asset Class X was crashing so the crash was caused by the strong USD. The main reason this is the true is because there are so many casual relationships that we can’t see.
Yes, the strong USD may have played a role in Asset Class X crashing, however the real catalyst of the crash could have been any one of a million unseen forces. With all of that being said, we have to go about trying to gain a deeper understanding of what is happening right now by using a time proven framework. And in many cases that framework will include some historical data. It's just important to remember as you begin to connect dots and paint a picture that correlation is not causation, and vice versa.
Good Cop or Bad Cop?
So the $64,000 question is what kind of rally are we currently seeing in the USD? Here is a breakdown of what has occurred since the USD started to rally after hitting an intermediate-term bottom back on July 4.
The USD has rallied 19% over the last 31 weeks. Over that time period, the USD has only declined in 6 of the 31 weeks and until last week it had gained in 6 consecutive weeks. Just one look at a weekly chart of the USD and you can see what can only be described as the parabolic move of the USD over the last 7 months.
This type of move in the USD has implications across several different areas of the global economy: currency markets, US corporate earnings, commodity markets and the global economy itself.
Clearly a strong USD will have implications across a wide range of currencies. The currency markets that have been hardest hit have been the emerging economies. The most pronounced of these economies is Russia, where the Russian Ruble has lost half its value since July.
Of course, not all of this crash is solely on the back of a strong USD; but when markets start moving at such a fast pace it can have disasterous and widespread implications.
Other emerging economies that have been impacted are Brazil, the Real is in crash mode, down 22%. The Singapore Dollar and the Mexican Peso are both down around 16%. The number of currencies with 10% moves over the last year is now close to historical highs. The number of currencies hitting crash mode by declining more than 20% is growing higher as happened in previous waves of USD strength.
US Corporate Profits
Generally speaking, corporate earnings are the main drivers of US stock prices. With that in mind, a strong USD can have negative implications for US based companies, especially those whose sales are weighted more towards international rather than domestic.
From a historical perspective, periods of USD strength have been associated with a larger number of companies missing sales estimates and more companies guiding lower for future quarters as opposed to when the USD is low or falling. Based on data by FactSet, 87% of companies are guiding lower for the next quarter.
This percentage is well above the average of 71% of companies guiding lower and it represents the highest percentage in the last 34 quarters.
To wit, this is what Proctor and Gamble had to say last week, "The outlook for the year will remain challenging. Foreign exchange will reduce fiscal 2015 sales by 5% and net earnings by 12%, or at least $1.4 billion after tax.
We have and will continue to offset as much of this currency impact as we can through productivity driven cost savings…We are adjusting fiscal year earnings targets accordingly.”
Proctor and Gamble is not alone. US corporations have been operating in a weak USD environment for years. You can expect that a 20% move in the USD over 7 months will begin to wreak havoc on corporate earnings across all sectors of the economy.
Obviously the impact of a strong USD on the commodity markets is much publicized so I want rehash too much. But in the context of trying to understand what is happening right now in the world, I’d like to share a few facts with you. I monitor 2 proprietary indices related to the commodity markets, one is energy based and the other is food based. The energy index has fallen 58% since last July.
Since the early 90’s, the only time period that even comes close to the kind of decline over such a short period of time is the Financial Crisis. From July 2008-January 2009, the energy index fell 68%. So, from an energy perspective, we are within spitting distance of mirroring what happened during one of the worst crisis the global economy has ever seen.
How's that for context?
The food index has fallen 32% since July. Again, the only other comparable time period was the Financial Crisis, when the food index fell 50% over that same July-january time period.
Relating back to my Danger Disclaimer, it should be noted that my food index has fallen 44% since peaking back in September 2012. All of this decline occurred between September 2012 and September 2014. During which time the USD was range bound between $78-$84. Correlation is not causation.
Finally, the impact of the USD strength on the global economy. An economy’s GDP or other economic growth numbers are always reported in the local currency.
However, if you were to price the entire global economy in USDs, you begin to see something interesting playing itself out. The global economy is roughly $75T when priced in USD. During the Financial Crisis, the global economy, when priced in USD, had a 10% contraction, losing $7T.
Since July 2014, the global economy, when priced in USD, has lost $4T or 5%. Here again, we are finding that the only comparable time period in the past to equate what is happening now is the steepest financial crisis we’ve seen since the Great Depression.
Leaving rates too low relative to the underlying growth of the economy for this long is an experiment never before tried. Likewise, coming off that type of party punch has never been attempted either.
Zero rates forced investors around the world to search for higher yields across all asset classes. A large number of investors used leverage to reach their yield targets. The downside risk going forward is that we see more and more capital inflows into the USD.
The more leveraged trades are unwound, the more volatility we will see in commodities, currencies and other asset classes. It can become a cascading effect as developing economies get crushed as capital rushes back into the US.