I thought this article was a fairly good summary. If Zacks is correct about the effects of a stronger dollar being less harmful to small caps, it could bode well for some of the semis/semi-equipments.
As the Market Turns
by Mitch Zacks, Senior Portfolio Manager
No need to let our emotions get the best of us.
The U.S. dollar has risen around 4% relative to a trade-weighted basket of other currencies from mid-June through October. Generally speaking, a higher dollar will hurt GDP growth but should actually help the U.S. equity markets.
This article will explain why.
For starters, U.S. GDP has been relatively strong following the extremely weak first quarter of 2014 which was due primarily to poor weather. Additionally, U.S. corporate earnings in aggregate have actually been coming in better than expectations while interest rates have remained low.
The unemployment rate continues to gradually decline towards pre-recession levels. Despite relatively low unemployment there is a tremendous amount of slack in the labor market and as a result, inflation has remained benign.
Although unemployment is falling, the labor force participation rate is at historic lows. The net result of the low labor participation rate is that there is not a tremendous amount of wage inflation and without wage inflation we do not see any price inflation.
Current expectations are for inflation to be below the Federal Reserve's target of 2% in 2015 and only hit the 2% target in the latter half of 2016. The economy as a whole is benefiting from higher asset prices across the board - real estate, equities, and fixed-income instruments - all of which is boosting confidence and increasing consumption.
Despite these positives, the stock market was hit over the past four weeks with several economic surprises that put pressure on the equity markets. Each of them led investors to believe that corporate earnings would be weaker than expected. The market sold-off not because of the fear of rising interest rates but rather because of the fear of weaker earnings.
The Biggest Issue for the Market Today
Right now, data coming out of Europe indicates a potential slowdown. It looks increasingly likely that the lack of GDP growth and the potential for deflation in Europe will require more aggressive action by the European Central Bank.
Additionally, as a result of Putin's action in the Ukraine, there is the rising concern that economic sanctions could effectively start a trade war that would add to the weakening GDP picture in Europe. Add to this the rise of ISIS in the Middle East which could destabilize oil production. On top of that we have a growing panic of Ebola, a weakening Chinese economy, and if that were not enough, Ben Bernanke let his former colleagues at the Federal Reserve know that mortgage lending standards have become too tight.
Despite all these shocks, the market is less than 5% off of its highs that were hit in mid-September.
Why Are Stocks Still Looking So Good?
The reason is twofold: First, corporate earnings have been relatively strong with companies like Caterpillar ( CAT ) and Microsoft ( MSFT ) surprising to the upside. Second, the European Central Bank has signaled they are actually going to leave the ghost of potential inflation in the past, not self-destruct, and start to be more aggressive in stimulating their economy.
Essentially, the turmoil of the past four weeks seems to have not been reflected in earnings numbers and has actually caused the central banks to adopt a more aggressive stance in terms of monetary policy. The net result is that after selling-off the market rebounded nicely.
It is becoming clear that the austerity measures and relatively tight money policies pursued by Europe following the last recession has caused a divergence between rates and GDP growth in the U.S. and Europe.
The result of this divergence between the growth in the U.S. and the rest of the developed world has caused the U.S. dollar to appreciate. The good news is that this could potentially be positive for stock prices. The bad news is that it will definitely be negative for GDP growth and corporate earnings.
Let me walk through what is likely to happen:
1. A potential 10% rise in the dollar will increase the price of exports and lower import prices. This negatively affects GDP growth and corporate earnings. Because 45% of the revenue from the S&P 500 comes from overseas, a higher dollar means less competitively priced products and lower sales.
2. However, a higher dollar causes goods that people buy to fall in value.Think of all the imported items sold by Wal-Mart. A higher dollar means the cost to Wal-Mart to buy these goods is lower. Additionally, a higher dollar also results in lower oil prices and lower commodity prices. The net result is that the higher dollar puts downward pressure on inflation and helps consumers.
3. The net result of 1 & 2 above is that GDP slows from lower exports and inflation remains lower for longer than is anticipated. The combination of lower than expected GDP growth and lower than expected inflation will keep interest rates lower for longer than currently anticipated.
4. Lower than expected interest rates means that all financial assets should rise higher than expected. For the S&P 500, if you weigh the negative effect of lower exports with the positive effect of lower interest rates, you arrive at a very clear plus for the stock market.
Additionally, it is important to realize that not all companies are exposed to export fluctuations. Most notably, small-cap stocks are less exposed to falling exports than large-cap stocks to exports.
As a result, the higher dollar should help small-cap stocks relative to large cap stocks. I would also expect interest rate sensitive industries such as homebuilders to rebound as well as companies such as retailers that will benefit from increased consumer spending. All of this points towards small-cap retail companies generating stronger returns over the next year than large-cap multi-nationals.
Ultimately, I continue to believe that the Federal Reserve is going to run the economy hotter for longer than what investors are expecting. Part of the reason is that a strong dollar gives the Federal Reserve more leeway as it keeps inflation lower than previously anticipated. With the Federal Reserve and every other major central bank still in easing mode, and with U.S. corporate earnings coming in relatively strong the bull-market remains in place. |
