Don’t Fight the Rising Dollar!

Periods of dollar strength are deflationary in the context of the current dollar-centric global monetary system. A strong dollar is generally associated with global inflows into the U.S. either because the U.S. provides superior returns on capital relative to international markets or because high levels of risk aversion drive global capital into the “safe-haven” U.S. capital markets (liquidity, transparency and rule of law).

Periods of dollar strength are the two corners of the “dollar smile” as previously discussed  (Link ) and as shown below.

 

Dollar strength saps liquidity out of international markets, especially in emerging markets where governments and companies  are overly reliant on dollar funding because of shallow domestic capital markets. The combination of higher funding costs for these borrowers and flight capital often results in emerging market financial crisis, 1980, 1997  and 2008 being some of the most painful episodes.  Because of the ongoing surge in the dollar in 2022, we should expect that emerging market economies and asset prices will be under significant stress for the time being.

Because most commodities and a significant amount of global debt are  priced in dollars, a rising dollar depresses global demand and economic growth. This impacts global corporate margins and profitability , including American exporters and domestic industries that compete against foreign imports.

The deflationary nature of dollar strength has a strong impact on global stock market returns because it depresses the earnings of cyclical companies, particularly commodity and industrial companies and banks. Global stock markets in general and emerging markets in particular have much greater exposure to cyclical industries and therefore suffer more during these periods. In the U.S. market, industrials and multinationals with heavy foreign exposure also suffer from a strong dollar. The chart below shows how this phenomenon plays out in the U.S. stock market. During periods of dollar strength (1997-2000) and 2012-2021), the Nasdaq index dramatically outperformed the Dow Industrials Index because the Nasdaq is composed mainly of growthy, long-duration stocks while the Dow includes mainly cyclical businesses such as industrial and banks.

The chart below shows the impact on Dow Index earnings  caused by strong dollar deflationary periods. The three periods of dollar strength since the inception of the fiat dollar regime in 1971 are highlighted by the dark bars.  We can see flat to negative earnings in the first two periods and very choppy earnings in the current third period despite the Trump corporate tax cuts and huge stock buy-backs (the final leg up in earning was driven by the recovery in commodity prices in 2021.)

The charts below show the strongly negative effect that a strong dollar has on corporate earnings in emerging markets. The first chart shows that earnings  (in nominal dollar terms) for Global Emerging Markets (MSCI EM Index) were highly depressed during the last two phases of dollar strength (1997-2002) and 2012-2021.  The following chart shows the poor earnings performance of Chinese stocks, over the past decade despite  the RMB’s appreciation over the period, which is a testament to the poor governance and the deflationary effects of overinvestment in industrial capacity and debt expansion. Next, we see the same for Brazilian corporate earnings which by the end of 2021 have still not returned to 2012 levels in nominal dollar terms, despite very strong earnings growth for commodity producers in 2021. Same for India, which barely returned to 2012 earnings level in nominal terms in 2021 even though the Indian economy has enjoyed high rates of GDP growth. Mexico and Korea show a similar story. The one outstanding exception is Taiwan, which has seen good earnings growth because of strong links to the  global technology sector.

The history of emerging markets shows that practically all earnings growth comes in periods when the dollar is depreciating. The current dollar upcycle will eventually turn, bringing better prospects for investing in EM assets. Rising inflationary pressures and buoyant commodity prices may portend that a change is coming.