What are the Implications of a Strong Dollar?

We will continue from the last article about the causes of the strong dollar. Today we will discuss the implications of a strong dollar and what it means for investor. I really like this quote about the health of the U.S. economy: When America sneezes, the world catches a cold. As the dominant currency in the international market, the surging of the dollar’s value has both positive and negative implications not just on the U.S. domestic economy but also on the global economy.

 

Source: http://thumbs.dreamstime.com/z/strong-dollar-weak-euro-conceptual-illustration-hitting-currency-figure-white-background-49218515.jpg

 

Implications on the economies and markets

           The first major implication of a surging dollar is its adverse effect on the earnings of U.S. multinational companies which has a large proportion of revenue generated from foreign market. Given a strong dollar in exchange rate, the sales of companies in foreign currency is discounted when it is converted into U.S. dollar term. This is known as “currency risk”. The Washington Post reported that Johnson & Johnson, whose sales from international operation account for more than half of its total sales, posted a drop in sales of 0.6 percent in the fourth quarter, although there was an increase in prescription sale. Figure 1 shows that 46.3 percent of the total sales of the S&P 500 companies are generated from outside the U.S.

           The fact that the earnings of U.S. companies are lowered due to a strong dollar is only one side of the argument. A strong dollar benefits those U.S. companies who import materials from foreign countries. Because of a surging dollar, the materials can be bought at a cheaper price, thus reducing the cost of production and increasing the profits margins, according to Keith Lerner. The Washington Post also reported that the aluminum supplier company Alcoa posted a solid profit in the fourth quarter of 2014. Thanks to the strengthening dollar, Alcoa imported its materials at a lower price from Australia, Brazil and Jamaica. Despite a rising dollar, Alcoa sales were not significantly discounted, since most of its sales are generated in the U.S.

 

Figure 1: S&P 500 companies’ foreign sales as a percentage of total sale

Source: Mackenzie Investments

           

One positive benefit of a strengthening dollar is that it drives down price of imported goods to the U.S. and keep inflation at a low rate. Cheaper goods can improve the purchasing power of American consumers and grow the demand in the economy. The U.S. low inflation rate, despite the Federal Reserve’s past aggressive bond-buying program and increase in money supply, is partly attributed to the low oil price. The low inflation below the Fed’s target of 2 percent has prevented the Fed from raising the interest rate which could bring about volatility in the market and increase the cost of borrowing.

Implication on international trade

A rising dollar could also jeopardize the competitiveness of U.S. export companies in the world market which could lead to increased trade deficit. Given that goods in a strong currency is more expensive in countries with depreciated currency, the U.S. export products become less attractive to foreign consumers which would reduce the sales of American products. Furthermore, a strong dollar also makes it more difficult for U.S. producers to compete domestically with cheaper imported goods from countries with weaker currencies when converted from a weak currency into a strong currency. Such disadvantage could force U.S. producers to lower its selling price and profit margin, affecting the earnings of the company. A strong dollar could be a major hindrance against full employment recovery, wage growth and the U.S. economic growth rate. While it can adversely affect the U.S. producers, foreign producers can reap the benefit by boosting their exports to the U.S. even further.

However, while the U.S. producers face barriers in competing against other countries with weak currencies, the U.S. consumers are the winners whose surplus and purchasing power are increased. According to the World Bank’s data, the U.S. export of goods and service relative to its total GDP was only 13.5 percent in 2013. As a consumption-based economy, the U.S. should gain from a strong dollar in an aggregate effect.

 

Implication on investment

Return of investors from foreign market is also diminished due to a strong dollar. Although the return is high, it will be reduced once converted into dollar, thus reducing the overall returns. For example, the MSCI EAFE index or Europe, Australasia and Far East of developed market stock has risen 4.5% by September in its local currency. The return once converted into U.S. dollar was negative 1 percent (Kelly, 2014). Thus, investors who aim to diversify their investment portfolio by investing in foreign stocks should take into account the currency risk as a result of currency depreciation against the dollar in Europe, Japan and other markets and the fact that their return in foreign currency is reduced significantly when converted to the U.S dollar term.

Mackenzie Investments advised its investors that in a strong dollar climate it is wise to invest in U.S. equities but selectively pick the U.S. companies that benefit most from a rising dollar. Those companies should not have much exposure to currency risk and have most of their business operation in the U.S. and generate most of the sales within the U.S. Moreover, those companies should benefit from the cheaper import material from abroad. The recommended sectors are utilities, consumer staples, healthcare and telecommunication. Moreover, Mackenzie Investments also encouraged investors to favor mid- and small cap companies, since most of these companies’ businesses are operated domestically and do not face with currency risk significantly.

Emerging markets may suffer the most from a strong dollar. Flanders and Dryden (2014) claimed despite relishing the boost in exports to the U.S., some nations of the emerging markets may face high inflation rate and foreign capitals diverted from within the countries to other stable markets which could results in “serious market volatility” as experienced during the Asian financial crisis in the 1990s. The two J.P. Morgan’s analysts also stated that equity prices in emerging market economies are negatively correlated with the trade-weighted dollars. This phenomenon may be explained by the fact that the dollar generally depreciates when the commodity price is low and foreign capitals flowing out of the emerging economies. They also found that countries of EMEA (Europe, Middle East and Africa) and the U.S. dollar have a -0.31 correlation, MSCI Emerging Markets Index and the U.S. dollar has a -0.82 correlation and Latin America economies and the dollar has a -0.86 correlation.

 

Will the dollar continue to rise?

The recent trend of the dollar appreciation caused currency experts and investor to bring their concerns on “Dollar-Euro Parity”. When two currencies is at parity, it simply means that both currencies have the same value and are traded 1:1. Robin Brooks, a strategist at Goldman Sach, predicted that Dollar-Euro parity will take place in the fourth quarter of 2015. The strategist even further forecasted that the Euro could be traded at a low 0.80 dollar by the end of 2017, which will be the lowest exchange rate since the inception of the Euro currency.

Predicting the movement of the currency exchange rate is a challenging analysis. Whether the dollar will continue to rise takes into account many factors. First, it depends upon the state of the U.S. economy, that is, whether the U.S. economy can still outperform the developed market. The outcome of the ECB’s version of quantitative easing and expansionary monetary policy still remain to be seen and it is too early to judge whether the QE could attain its goals. Forbes reported that if Europe’s economy showed sign of positive economic data, the dollar-euro parity will unlikely happen.  Second, the strength of the dollar also depends upon the decision of the Federal Reserve of when to raise the interest rate and by how much. Given the current positive data from the labor market and price stability, the Federal Reserve’s interest rate hike is imminent and is likely to happen by the end of 2015 which is predicted by many analysts.

Hedging against the U.S. dollar

In the climate of a rising dollar and foreign currencies depreciation, hedging against the dollar has been popular among investors who aim to mitigate the currency risk of investing in foreign markets. Hedging currency can take many different forms, including sophisticated derivatives, that is, forward contract, foreign exchange swap, currency options, purchase of a currency-hedged mutual fund or exchange traded fund (ETF).

The method of forward and option to hedge is sophisticated. Since the currency-hedged ETF is more convenient, investors start to pour fund into ETFs to protect their investment from a surging dollar. The Wall Street Journal (WSJ) reported that currency-hedged ETFs, mainly offered by WisdomTree Investment and Deutsche Bank, is currently worth 50.3 billion dollar thanks to the growing concerns of the recent trend of a rising dollar. The figure below from the WSJ also showed that the returns of currency-hedge funds consistently beat the returns of unhedged funds since 2014. However, it should be noted that the performance of a fund within just a short period of time does not represent a full and complete picture of the returns in the long run nor does it indicate that a currency-hedged fund will continue to exceed the return of an unhedged fund in the coming years. Since the currency-hedged ETF is new to the market and hedging can be expensive and reduce the return when the global economic condition and world market change.

The WSJ also presented an argument against currency hedging. Hedging against the dollar can yield benefits in the short run given that the dollar is rising at the moment. However, currency movement goes in both directions - a currency can appreciate and depreciate over a period of time. In the long run, the currency risk is minimal and returns should be generally the same for hedged and unhedged funds. However, there is a cost incurred when you decide to hedge which could diminish your overall return in the long run.

Figure 2: Currency-hedged ETFs asset, one year return of hedge and unhedged funds

Source: The Wall Street Journal

 

Whether or not to hedge against currency, investors are advised to gauge the magnitude of the currency risk and its degree of likelihood, understand your time horizon in holding the securities, weigh the potential benefits and costs of hedging.

 

Conclusion

As a dominant international currency, the value of the dollar against other foreign currencies results in several implications which bring concerns to investors and the world market. Several factors are attributed to the rise of the dollar value in relative to other foreign currencies, including the relatively more impressive U.S. economic growth compared to other developed nations, the potential of the Federal Reserve’s interest rate hike, the quantitative easing program of the ECB and BOJ, capital inflow to the U.S. market and the U.S. energy revolution.

Major implications include the decrease in earnings of U.S. companies whose sales are mainly generated in foreign countries, the decrease in the return of investments in foreign market once converted to the U.S. dollar, the negative impacts on the competitiveness of the U.S. producers, the more expensive U.S. export products and the cheaper import products to the U.S.

Against the backdrop of the current economic condition, a currency strategist at Goldman Sachs predicted that the dollar and the euro would be traded at parity by the 4th quarter of 2015 and the euro-dollar exchange rate could even further drop to the lowest rate at 0.80 dollar per euro by the end of 2017. However, the prediction would not remain valid if positive economic data in the eurozone start to emerge in the near future. In the time being, investors need to pay attention to whether or not the ECB’s quantitative easing program is a success.

In the current rising dollar climate, currency hedging can yield higher return and protect investments in the foreign markets in the short run. However, the returns of hedged and unhedged funds are generally the same in the long run because the value of a currency can either appreciate or depreciate. Investors need to take into account the cost associated with hedging which could affect their overall returns. Investors should also understand the magnitude of the currency risk, time horizon of the investment whether investors opt for a short term investment or a long term investment and weigh the costs and benefits of hedging before deciding whether to hedge against the dollar.

What are the Causes of a Strong Dollar?

Source: https://acethetrade.files.wordpress.com/2011/04/us_dollars-6907.jpg

 

A few days ago I learned that my good old friend has received an offer to pursue his master's degree in Economics from two of the most prestigious universities in Australia. While I am a bit disappointed that it is highly unlikely for him to study in Canada (since I could visit him in Canada easily), I am also happy that Australia could be his next pit stop because Australia is a wonderful country and my heart has always had a special place for Australia. I still remember some of the lyric of Australian National Anthem "Advance Australian Fair". As we were talking about his degree, I told him that he was very lucky to study in Australia, owing to the fact that as of the late the Aussie dollar is relatively much weaker against the U.S. dollar (USD) which means he could buy more Aussie dollar with his USD. To my surprise, he told me to shut up and confidently said he already know all of the stuffs that I’ve said. The sheer arrogance of this dude who is admitted to the top Australian universities is beyond belief. I also told him that I wouldn’t be able to discuss anything with him related to economics once he completes his PhD. Anyways, all jokes put aside, I think it would be an awesome idea to discuss the causes that leads to a strong dollar, thanks to the brilliant discussion on Australian dollar and USD exchange rate. Let’s get to our main discussion: the causes of a strong dollar.

Introduction

The United States dollar has appreciated gradually against other currencies over the past two years. In fact, the U.S. Dollar Index, which measures the value of the dollar in relative to a number of major currencies from developed market comprising of Euro, Japanese yen, Pound sterling, Canadian dollar, Swedish krona and Swiss franc, has risen around 15 percent since June 2014. The euro was traded at 1.058 dollar as of April 2015, according to Bloomberg’s website. The dollar appreciation has brought legitimate concerns to multinational companies, investors and the international market.

    As a result of globalization, the world has become increasingly intertwined and the role of currency exchange rate in promoting economic growth has also been amplified accordingly. The strength of this dominant and international currency known as the U.S. dollar can have broad implications to not only the U.S. market and economy domestically but also the global market.

Causes of a strong dollar

Many currencies of both developed and emerging market have depreciated significantly against the dollar in 2014 which can be attributed to several factors.

           The first factor is that the U.S. economy is recovering at a much faster rate compared to other developed countries counterparts. In contrast to sound economic recovery and low unemployment rate (5.4%) in the U.S., the European Union members are still plagued by mounting debt crisis, high unemployment rate and decrease in consumers and investors’ confidence. Spain’s unemployment rate was at 26.6 percent, according to the World Bank data in 2013, meaning that 1 in 4 person is jobless. The World Bank data in 2013 also showed that unemployment rate among youth was around 57.3 percent or half of the young people is without a job. Greece is still struggling to cope with its high debt and austerity economic policy which the world fears that Greece may exit the EU in the near future. In Japan, despite its expansionary monetary policy and quantitative easing as part of what is known as Abenomics, experienced a surprise technical recession in the second and third quarter of 2014, largely attributed to the government’s sale tax increase from 5 percent to 8 percent to pay down Japan’s huge amount of debt. A healthy and growing economy is often associated with the rise in investor confidence.

 

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           Another major cause is the U.S. Federal Reserve has ended its Quantitative Easing policy and begins to tighten its monetary policy. Many analysts expect the Federal Reserve to raise the interest rate in 2015 given that the U.S. healthy economy is showing positive sign of normality and full employment. Contrastingly, the European Central Bank (ECB) and the Bank of Japan (BOJ) are implementing its expansionary monetary policy and Quantitative Easing program aimed at stimulating the demand in the economy and targeting inflation rate at around 2 percent by significantly increasing the money supply in the economy. The ECB has announced a 1.1 trillion euro quantitative easing plan by making a monthly purchase of 60 billion euro of government bonds and private sector assets. The Wall Street Journal reported that the BOJ also intensified its already aggressive quantitative easing plan by raising its annual asset purchase from 60 and 70 trillion yen to around 80 trillion yen (730 billion dollar). J.P. Morgan’s strategist Dr. Kelly stated that investors are pouring capital to the U.S. by buying the U.S. dollar expecting to reap the benefit when the Federal Reserve begins to raise the interest rate in the near future.

           Third, the U.S. 10 year government bond is currently yielding around 2 percent, although is a small return, is relatively more impressive than the near 0.2 percent yield of Germany’s 10 year government bond and other developed market. The higher U.S. government bond yield has attracted a huge capital inflow into the U.S. and increased the demand of the dollar. The simple economic concept of the law of demand and supply will explain that the increased demand of the dollar will accordingly amplify the price of the dollar in the international currency exchange market.

           Another likely contributing factor is the revolution of U.S. energy which cut U.S. import of oil significantly over the past few years which was made possible by the previously high oil price which enabled U.S. energy companies to make profit from extracting oil from the oil shale. In 2005 the U.S. imported 12.5 million barrels of petroleum a day or 60 percent of the total daily petroleum consumption. In 2013 the percentage of daily imported petroleum dramatically dropped to only 35 percent or 6.6 million barrels, according to Dr. Kelly’s article. Such reduction in oil import has reduced the U.S. trade deficit and saved billions of dollars. According to Flanders & Dryden, strategists at J.P. Morgan, all else being equal, a lower supply of dollar in the market leads to a dollar appreciation.

The sharp fall in commodity prices has also been a major negative impact on the economy of emerging markets. Countries which rely on commodity exports including Russia and Brazil have seen their currencies value drop sharply against the dollar.

This post is getting uncontrollably long and so for the sake of simplicity, we will end it here. There will be a continuation of this post and we will look at the effect of a surging dollar on the U.S. economy, the world economy and what it means for investors.  Until then, have a great weekend.   

Why Can’t a Country Print More Money to be RICH? (Part 1)

By: Econoobics

Have you ever thought that a country could become rich by just printing more money? But why wouldn’t they do it? This idea of printing more money makes a lot of sense, because we use this paper which we call money to buy all sorts of stuffs that we can think of, ranging from necessity items such as food and clothes to luxury goods such as expensive tablets and jewelries. What that means is that the government can just ask the central bank to print more money so that the government itself can pay civil servants higher salary and invest in the country’s physical capital, including roads, bridge and irrigation. With great amount of money comes great power for the government. Wouldn’t it spur economic growth and development much faster? Eventually, everyone is wealthier and can relish a better quality of life on this wealthy island. This is one perfect scenario. I for once asked myself this question and the quest of finding a simple explanation led me astray. In other words, I couldn’t find the right answer to explain it. So I asked that particular question to a friend of mine and he could explain it in a much better way than I ever could. So now I am willing to explain it in a more convincing and simple way than he ever could.

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So let’s analyze the question together, shall we? Is it true that making money out of thin air, that is printing money, can make a country become rich at an instant? To answer this question, we have to ask ourselves what factors determine a country’s prosperity. In a fancy language or technical term, we need to understand the source of economic growth of a country. From the previous article, we learn that economic growth is the increase in output including goods and service within a specific period. Basically, the vast amount of outputs produced (cars, electronic devices, agricultural products, home appliance and other goods and services) is what makes a country rich and grow. To be more precise, it is the level of productivity, labor and capital with which a country can utilize to create goods and service for the people. These are the three main sources of economic growth. We should try to think of the economy as an apple tree which gives us apples to consume. The more the apples grow on the tree, the more we have apple to eat. With our below example, you will see that having a vast amount of paper that is money would not bring about such determinants of economic growth and definitely would not lead to prosperity. We will have a further discussion on the sources and determinants of economic growth in the future topics, but for the time being we will focus on everyone’s favourite topic — Money. (Almost everyone loves money, right?)

Source: http://fm.cnbc.com/applications/cnbc.com/resources/img/editorial/2013/08/13/100960148-169117081.530x298.jpg?v=1394819300

The above paragraph may sound somewhat confusing, so let me draw a simple example to better your understanding. Suppose that I was employed by the central bank of a country called Richland as the country’s Chief Economist and with my brilliant idea to boost prosperity on this peaceful island, I would adopt what economists calls an expansionary monetary policy, which means printing more money, so that the government can finance its huge amount of public expenditure to implement its 10-Year-Leap-Forward Strategic Plan. Our first priority is to increase the salary scale of our hardworking civil servants (police, teachers, ministers and other government officials) so that they can have more money to spend. After all, printing money is not a serious hiccup, because what we need are just ink and paper. At the end of the month, after our civil servants receive their increased monthly payroll, it’s time to let the spending spree begin. Everyone is better off now, so what we do with our money is spending and allocating some of the income for saving. For my case, the first thing that I would do is going to a Mercedes car dealer to order a new Mercedes-Benz S500. Then I would buy a new convertible laptop, buy a new phone, buy new clothes, order fresh organic farm products and other sort of things that I could think of. Now not only I who can afford a Mercedes-Benz S500, but also my colleagues, my friends, my teachers and my doctors can also afford it as a result of the abrupt and massive increase in their income. The question facing the car dealer now is that with this excess in demand for Mercedes sedans, should the car dealer raise the price of the car to maximize his profit or sell it at a normal price? Well, the answer is a no brainer. The car dealer would simply raise the price and sell out all of the cars. Still despite the extreme pricing of the luxury sedan, people are still queuing to buy a Mercedes and the car is now in a huge shortage (Assume that Mercedes is produce in Richland). To meet with this demand, the car factory needs to speed up its production of cars, but producing cars is not the same story as printing money. Cars take a lot more inputs before it can be produced. Those inputs include factory, assembly line, labour, wage, machine, know-how technology and the quantity of output that is able to be produced is limited. With this huge shortage in car and explosive demand, the price of the car definitely will skyrocket. This is only one story for a car company. How about the market of phones, clothes, food? The same story goes and price will certainly hit the ceiling, because production of these outputs could not meet with the excess of demand driven by the hike in monthly salary. After all, the capability of a country’s to produce goods and service is limited. This capability depends on its factor of production which are capital, labour and productivity. In contrast, the printing of more money did not help bolster the productivity of the economy, modernize the capital and upgrade the skills of the workers in order that more output can be produced. Let’s get back to our analogy of an apple tree. Our apple tree produces the same amount of apple for the consumers.

The aftermath of my great vision is the overall level of massive price increase within each sector of the economy which economists call hyperinflation. So are we better off? Say yesterday my salary was 1$ and I could buy an apple (real fruit not a tech product) for just $1. This morning my income is increased by 100% thanks to the Leap-Forward-Strategic Plan, so now I have $2 which I expect to buy 2 apples. But to my surprise the grocery owner tells me that the apple’s price is now $2. So with my increase in income, I still can only afford 1 apple. This is by no means I am richer whatsoever. I think with some of my examples you may probably have an intuitive feeling of why more money in each and every people’s pocket does not bring about prosperity as we wish. Our example of printing more money to massively raise the monthly salary of our government’s civil servants certainly does not spur economic growth but contrastingly results in unintended consequences that is a total catastrophe in the economy. Our story could go on and on. The price of a kilogram of rice may be 1,000,000 riva (a make-up currency) or a kilogram of sugar may cost 500,000 riva. It simply illustrates that our money is seriously devalued and the amount of money that is enough to buy a piece of bread yesterday may not be able to buy same piece of bread today. To sum it up, the increase in the money supply of the government only increases money in our pocket but does not increase the level of productivity of the factories or farms to produce more output to meet with our insatiable demand. In contrast, the over supply of money pushes the economy in a total chaos with extreme increase in the price level everywhere.

You may think that my example is just an imaginary situation and would never ever happen in real life. History taught us that the countries that defy the Principles of Economics often pay a heavy toll for their underestimation by printing more money to finance government deficit. We can draw empirical evidence from the past to prove this basic Economics principle which I will talk about in the next topic, hopefully. For now I hope we could understand the reasons why printing more money is not the right path to prosperity. Thanks to my extreme expansionary monetary policy, I am no longer hired as the Chief Economist of Richland. I hope to see you soon in Part 2 of this discussion.