The U.S. dollar’s strength has been unrelenting, with the trade-weighted dollar index at its highest level since March, 2020, and up 8.4 per cent year-to-date.
This can be traced to: 1) the risk-off environment in financial markets, which has seen the U.S. dollar benefit as a safe haven; and 2) the U.S. Federal Reserve’s aggressive tightening cycle, leading to positive interest-rate differentials, which in turn have supported the greenback.
Looking ahead, we expect the lagged impact of the U.S. dollar’s advance will exert a meaningful drag on U.S. corporate earnings, serving as a key headwind for stocks.
Since the start of the year, we have seen underperformance in stocks that derive a higher-than-average share of their revenues from countries outside the United States. Indeed, the S&P 500 Foreign Revenue Exposure Index is down 24.5 per cent year-to-date compared with the 20.5-per-cent decline for the S&P 500.
Part of this can, of course, be attributed to the economic challenges globally (Europe’s energy crisis, China’s ongoing “Zero COVID” policy, etc.), but the dollar’s rise has also played a big role. This is due to negative currency translation effects – that is, the process of converting earnings in a foreign currency into U.S. dollars is now less favourable from a financial perspective. By way of comparison, the S&P 500 U.S. Revenue Exposure Index – which is made up of companies that get most of their sales domestically – is “only” down 12.6 per cent year-to-date, outperforming the S&P 500 by about eight percentage points over this time.
There was a widespread belief that the second quarter earnings season was “not as bad as feared,” and embedded forecasts continue to suggest that it will be the low point of the year as well as in 2023. This strikes us as exceedingly optimistic given the inherent lags between tightening financial conditions – such as what has already occurred with the extent of the dollar strength – and the impact on earnings. Further to this point, our analysis has found that the relationship between the U.S. dollar and its influence on S&P 500 revenues is strongest at nine months, meaning that Q3 will really be the first time that the dollar’s rally from earlier this year will weigh on results.
In fact, based on their historical relationship, we expect that the move in the dollar thus far will exert a drag of just under 5 per cent on S&P 500 revenues. Assuming an unchanged profile for margins, this would also equate to a 5 per cent hit to earnings, yet another headwind – in addition to a rapidly slowing economy – heading into the Q3 earnings season.
With this in mind, we do not believe that earnings revisions, despite turning negative, have gone “far enough” to appropriately discount the current economic reality. This is a big reason why we believe lower lows are ahead for the S&P 500.
Finally, in terms of what sectors are most at risk from the lagged impact of the U.S. dollar, this would include: technology, materials, and consumer staples, which all have about 50 per cent foreign revenue exposure. Conversely, utilities, real estate and financials are much less at risk from this dynamic.
The bottom line is that the lagged impact of the U.S. dollar’s strength has yet to meaningfully weigh on U.S. earnings but will increasingly be a headwind in the quarters ahead. Position defensively. From our standpoint, in terms of equity exposure, this means an emphasis on companies with limited earnings cyclicality and strong balance sheets, which are better positioned to weather a looming earnings recession.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave. Brendan Livingstone is senior markets strategist with the firm.