U.S. Dollar Strength: the Advantaged and the Disadvantaged… but First CPI

By TRG Advisors on July 15, 2022

Persistent Inflation and Labor Tightness Underscores Fed Policy Tightening

The Fed continues to be behind the curve in its fight against inflation. Despite its aggressive policy, viewed as being front-loaded with heavy rate hikes (most recently 75 bps in June), inflation remains widespread and a serious threat. While raising rates is designed to curb growth, high inflation is more damaging long-term for consumers, and its persistence can be particularly damaging for lower-income populations with greater wallet share spent on living essentials.

June CPI reached 9.1% y/y, a new high amid the ongoing surge in prices. Inflation is being particularly emphasized in food and energy – a result of persistent shortages from historic underinvestment. Rental costs, roughly 32% of total CPI, also continue to increase due to low vacancy rates, higher mortgage rates forcing potential homeowners to rent, and the result of record home appreciation driving higher rental costs. In addition to higher widespread commodity costs, rising wages due to tight labor markets also continue to drive higher prices.

It’s evident that inflation remains a big risk, and the Fed has plenty of work. To lower inflation, the Fed will need to substantially slow demand as supply shortages persist. A result of such actions – slower economic growth and rising unemployment – could put the U.S. and global economy into a recession, which we view as increasingly likely for 2023.

U.S. Dollar Reaches 20-Year High

A cocktail of higher inflation, higher interest rates and geopolitical instability is driving the U.S. dollar index to 20-year highs. The U.S. dollar (USD) strength is particularly strong against other major currencies, like the euro (we see the Eurozone as a greater recession risk than the U.S.) and the yen (Japan is not adjusting monetary policy for inflation). Similarly, gold is reaching new lows as demand for the U.S. dollar demand exceeds demand for gold because of bonds’ ability to earn interest.

Chart 1: Year-to-Date Return on Gold and Select FX Rates¹

The U.S. dollar benefits from rising interest rates and geopolitical instability that leads market participants to search for safe-haven securities, including U.S. bonds. To invest in U.S. bonds, non-U.S. investors must convert their currencies into USD. In addition, the U.S. economy has been more resilient than many other nations because of greater energy independence and strong consumer balance sheets.

Beneficiaries of a strong U.S. dollar include American travelers, who have greater purchasing power overseas as they convert USD into foreign currencies. However, a strong USD can indicate significant challenges for emerging markets paying off dollar-denominated debt and potential contagion for global financial institutions. It can also create a headwind for corporate earnings as companies with overseas operations convert foreign currencies into USD for reporting, at less favorable exchange rates.

Corporate Profits at Risk

American companies with European sales are likely to see their profits dragged by conversion rate headwinds. As earnings expectations are already under pressure, with many analysts predicting downside risk to earnings, foreign exchange (FX) headwinds are expected to be a broad theme lending to this downside.

Microsoft (MSFT) warned in early June of FX headwinds as it lowered its earnings guidance. The company earns more than one-third of profits from overseas. Companies, including Coca-Cola, Medtronic and Salesforce, have shared similar warnings.² As FX headwinds impact a broad group of companies, with the common link being overseas sales, many are exploring their hedging tools to help manage the FX risks.

The downside risk to earnings is a factor because the S&P 500 Q2 and full year 2002 earnings expectations have risen since the end of May, despite persistent inflation, productivity challenges and slowing demand concerns. Analysts have largely refrained from lowering estimates, due to the broad uncertainty that has also lent itself to heightened market volatility. Forward guidance will be a big emphasis on Q2 earnings calls as analysts seek for better clarity. It’s expected that analysts revise estimates lower over the coming quarters.

Emphasizing U.S. Stakeholders of USD Strength: Exporters and Importers

America is a net energy exporter. And given the energy supply crisis, demand for U.S. energy exports is high. This contributes to U.S. dollar strength, required to purchase U.S. energy goods.

Strength in the U.S. dollar provides cushion for the U.S. consumer purchasing foreign goods. Particularly, Americans traveling overseas have greater purchasing power. U.S. companies that import from overseas suppliers can do so with greater purchasing power, potentially easing some of the higher inflation costs – though unlikely to reduce consumer prices. Alternatively, U.S. companies with sales overseas will be adversely impacted by the U.S. dollar conversion rate, and this is expected to broadly impact global companies in their Q2 earnings. A stronger dollar also makes U.S. goods and services more expensive for non-U.S. buyers, potentially weakening demand for U.S. exports.

Emerging Markets Risk

The pandemic and rising inflation has underscored a challenging environment for emerging markets, particularly those with large amounts of foreign debt. Sri Lanka is making headlines for its mass protests that resulted in its president fleeing and resigning, a result of inefficient access to essential goods and defaulting government debt.

While the situation in Sri Lanka has boiled over, many other emerging markets are facing similar challenges, grappling with the prioritization of paying down high levels of foreign debt, while providing access to high-cost essentials for its people amid a bottlenecked economy. Many emerging markets sold overseas debt during the pandemic when spending needs were high and interest rates low. Now, as global central banks tighten monetary policy, capital flows are being driven away from emerging markets and leaving them with heavy cost burdens.

According to Bloomberg, almost one-fifth of the $1.4 trillion emerging-market sovereign debt outstanding is due to foreign bondholders, trading in dollars, euro or yen. The Bloomberg Emerging Markets Local Bond ETF has fallen nearly 20% this year, with much of that money flowing into safehavens like USD-denominated bonds.

Chart 2: U.S. Dollar Rises as Emerging Market Debt Increasingly Becomes Distressed³

U.S. Dollar Strength has Global Consequences

As a result of persistent inflation and the Fed’s aggressiveness, the U.S. dollar index can go higher as a safe haven for international investors. A stronger dollar is expected to curb international revenues for U.S. companies while encouraging Americans to spend money abroad. According to Morgan Stanley analysts, extreme rallies in the dollar, like the one being experienced today, “typically coincide with major financial stress, a recession – or both.” ⁴