The ongoing economic recovery from the COVID collapse will star in the role of determining future corporate earnings growth. But the trajectory of the U.S. Dollar will play a key supporting role.
The U.S. Dollar Index has fallen 10% from its March highs. After rising steadily for 2 years, the index was near the high end of its 5 year range when the pandemic hit. An initial rally proved short-lived, and the reversal brought the Dollar back to the bottom of the channel. Since the end of July, the index has consolidated at support, while momentum has steadily improved. Earnings watchers should be mindful of how the currency resolves from this pattern.
Exchange rates affect earnings in two primary ways. The first is simply through a function of accounting. U.S. based companies with international business segments must translate the earnings of ALL their segments to a single currency. Consequently, changes in the relative value of the USD affect the translated value of incomes. Take for example a a foreign business segment that earns 100 ‘bucks’, where the current exchange rate is 1 ‘buck’ for 1 U.S. Dollar. Thus, those 100 ‘bucks’ are worth $100 in earnings to the U.S.-based business. Now let’s assume in the next period, the ‘buck’ weakens against the Dollar – instead of a 1:1 exchange, it takes 1.25 ‘bucks’ to make $1. The foreign segment again earned 100 ‘bucks’, but now they’re worth only $80 in earnings to the U.S. business. Earnings fell 20%. A key point in this example is that the reported earnings changed, but the economics of the business didn’t. Remember that international businesses aren’t actually trading all their ‘bucks’ for dollars at the end of each accounting period. In both cases, they’ll still have 100 ‘bucks’, all else equal. Of course, all else is never equal, so let’s talk about the second way currency movements affect earnings.
We live in a competitive global society, where information is more readily available than ever before. Thanks to the internet, consumers can compare similar items from dozens of suppliers with ease, and, more often than not, the lowest price wins. For global businesses, the consequences are clear: they have to buy and sell products at competitive prices or risk financial ruin. Given that many supply chains are global in nature, exchange rates play a major role. Let’s use another example. Assume a U.S. based company sells ‘widgets’ for $1. A foreign-based company purchases widgets and uses them to make their own products. Assume the exchange rate of ‘bucks’ to Dollars is again 1:1, and the foreign business uses 100 ‘bucks’ to buy 100 widgets. Now imagine the ‘buck’ weakens (Dollar strengthens) again. The foreign business can only afford to buy 80 widgets with their 100 ‘bucks’ now. They have a decision to make: accept only 80 widgets and sell fewer products to their customers, spend 125 ‘bucks’ to get the 100 widgets, or find someone else to supply widgets for a cheaper price. If they can, they’ll choose option 3. In this example, there is an economic impact from the currency movements – demand from overseas falls when the domestic currency strengthens.
In both cases though, a rising USD is a headwind for international corporate earnings. Conversely, a falling Dollar provides a nice tailwind.
So how much of an impact can currency movements actually have on stock market indexes? According to FactSet, about 40% of S&P 500 revenues come from overseas. That’s certainly large enough to be material to index earnings power.
And historically, it seems clear that the performance of the trade-weighted U.S. Dollar is related to corporate earnings growth. Check it out:
We shouldn’t expect this relationship to be perfect (the earnings growth of 500 diverse businesses obviously depends on more than simply the value of one currency relative to another), but it’s certainly one to keep in mind.
Uncontrollable government policies and unpredictable changes in consumer behavior will present plenty of challenges for U.S. businesses over the next year. Continued weakness in the Dollar would be a welcome respite.
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