PMC Weekly Review - May 13, 2016

A Macro View – Don’t Be Too Carried Away by Dollar Weakness

The dollar has struggled thus far in 2016, bucking the last two years’ strong upward trend when it gained 13% and 9% in 2014 and 2015, respectively, versus other major world currencies as measured by the U.S. Dollar Index (DXY). During the first four months of the year, DXY declined nearly 6%. A weak dollar helps companies that have significant international businesses, as their sales outside the US are worth more in dollar terms, even though they are doing the same amount of business. Currently, approximately one-third of aggregate sales of S&P 500 companies are generated outside the US.

Two major currency impacts on company businesses are the effects of translation and transaction. Translation effect involves the beginning and end values of the currency, regardless of the path in between. For example, if a US company has a subsidiary doing pure domestic business (such as utilities) in Japan, its sales will appear to be stronger by 13% in dollars this year, even though there is no actual business growth, as the Japanese yen rose 13% against the dollar during the first four months of the year.

But the other effect, transaction, does matter for most multinational companies. Transaction effect is not just about the beginning and end values of the currency, but more about the path, or the average value for the period, as businesses conduct currency transactions on an ongoing basis. The daily average currency value for the period is far more important to them. On that measure, the dollar decline has been quite modest so far this year. The daily average of DXY during the first four months of 2016 was only 3% lower than it was at the beginning of the year, and is still nearly 3% higher than the daily average of the first four months of 2015.

Envestnet | PMC believes the current dollar weakness is likely to be temporary. After surging over 20% in just two years (an unusually large movement for a diversified currency index), a counter-trend retreat is not unusual. The fundamentals supporting a strong dollar are still intact. There is little argument that the US has the strongest economic fundamentals among major world economies—solid economic growth, a strong labor market, and tepid inflation. For most other countries stuck either with anemic economic growth, deflation spiral, or both, there appears to be no end in sight. In terms of monetary policy, the divergence between the US and others can’t be clearer. Here in the US, the talk is focused on how many more rate hikes we will have for the rest of the year, or the additional excuses the Federal Reserve (Fed) can find to delay raising them. In most of the Eurozone and Japan, where negative interest rates are already in force, the talk is centered on how to get both rates and currencies to fall, and by how much. The inability and incompetence of central banks in both the Eurozone and Japan to drive their currencies lower were partly to blame for the weak dollar so far this year. They were explicit in their drive to push their currencies lower, but the execution (and the communication) was lousy. They will keep trying.

A strong dollar is not that dreadful, nor should we fear it. The 1990s was a decade in which the dollar was strong, but both the US economy and stock market prospered. Mercantilism, which is the notion that accumulating trade balances through protectionism generates wealth, is such a backward and petty economic theory that the US has long rejected it. Countries and economies obsessed with mercantilism are doomed to fail, while countries and economies that take a high road are destined to succeed.

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