- David Thatcher
US Equity Strategy - Dollar Implications
Citi’s FX strategists expect US dollar strength to persist, at least over the intermediate-term. This should favor US Large Cap as a relative safe haven. Impacts of further dollar strength on earnings are mixed. We put more focus on structural implications for global growth than on quarterly translation effects. Interestingly, the negative impact on further dollar appreciation to S&P 500 price action may prove greater than the positive from a falling greenback. Sector and style reactions to the dollar need context, and are evolving.
Business Trends > Dollar Direction — We firmly believe the rising dollar’s negative short-term impact on earnings in and of itself is a lesser consideration relative to a stock’s underlying business trends. To us, dollar direction provides more of a signal to equities on the condition of global growth.
Dollar Headwind to EPS — Long-term correlations imply a rising dollar has a lagged impact on earnings of 3-6 months. The +11% rise in the trade weighted dollar in the past year could hit early 2023 index level earnings by -$15-20. This is well recognized in our 2023 S&P 500 EPS estimate of $215, but not in bottom-up consensus of $239.
Opposite, But Not Equal, Reactions — Our analysis implies that a dollar reversal from here would not help the S&P 500 as much as the recent dollar strength has hurt the index. Dollar versus equities correlations are typically negative unless the US is viewed as the epicenter of a global growth scare (i.e. the onset of the Financial Crisis).
The Best House — US Large Cap is a likely relative winner in the global equity landscape if dollar appreciation persists, despite EPS headwinds. A stronger dollar delineating even more severe growth concerns likely drives investors in a relative sense to the US. Large likely leads Small Cap given the latter’s risk-on connotation.
Changing Style Relationship — Dollar appreciation has coincided with Growth underperformance over the past 6 months. That is not the norm historically. We believe Growth could be viewed more favorably versus Value if further dollar upside signals lesser macro confidence. Investors likely shy away from cyclicals in that case.
Further Dollar Strength? Context Required.
We briefly commented on the appreciating US dollar when it first caught our attention in mid-July. Our broader view on dollar impacts is mostly unchanged. A rising dollar’s negative impact on short-term earnings in and of itself is a lesser consideration for us relative to the structural implications of a higher for longer US dollar influence on underlying business conditions and trends. This perspective can help in assessing company specific earnings releases in the weeks ahead relative to aggressive index level consensus growth expectations for 2023.
What has changed since the summer is the level of the dollar (Figure 1), and the more widespread attention that is being paid to it (Figure 2). The broad trade weighted US dollar index is now at a new 20+ year high. Dollar impacts on US corporate earnings are likely greater given this notable currency move, but still, context is needed.
EPS misses due to currency effects will likely be looked through for most companies so long as constant currency metrics continue to trend well. The real concern to us is longer-term dollar strength read-throughs. A stronger greenback due to flight-to-safety reactions against a much weaker global growth outlook is the bigger headwind. This may actually lead investors to rethink risk asset allocations or company exposure to weaker global markets (assuming the US is a relative recession haven). For now, we feel it important to review various dollar connections, both to earnings and performance (both absolute and relative).
On the earnings front, we review broader index sensitivities to currency appreciation, but also look at sector nuances. The move we have witnessed in the dollar over the past year likely creates a -$15-20 headwind for index earnings in the year ahead. Some of this is recognized in our $215 2023 EPS estimate as the US dollar is an input to our top-down index earnings model. As we have suggested on several occasions, bottom-up consensus of $239 for next year looks very aggressive. Benign modeling for the currency moves in company specific projections may be part of this.
As for performance, we consider the changing nature of dollar correlations over time, assess equity sensitivity to currency fluctuations in different environments, and test relative performance correlations. Historically, a high and rising dollar creates a worst case scenario for the S&P 500. Unfortunately, data suggests a dollar reversal from here likely helps risk assets, but not to the same degree it hurt them on the way up. As for relative performance, the S&P 500 is likely to lead non-US stocks and smaller caps on further greenback strength. Growth outperformance could reemerge as additional dollar upside could make less traditionally cyclical names more attractive.
Long-Term Earnings Connections
In this section we consider the potential impacts and sensitivities to earnings from a rising dollar, even though we believe the direct currency translation impact on EPS should be a more secondary consideration for investors. To examine the dollar and fundamental relationship we consider 25 years of trailing 12-month data.
First, the data suggests that the dollar relationship to earnings is not immediate. Per long-run correlations, the dollar is typically a 3-6 month leading influence on earnings. Sales relationships are strong at 6-12 months, but sensitivity is much lower (Figure 3).
Second, we go a step further and look at dollar sensitivity. As alluded to above, earnings show much higher beta to dollar moves than S&P 500 top line. If we focus on the 3- and 6-month leading beta in Figure 4, every 1% change in the trade weighted US dollar would affect index EPS by an estimated $1.40-1.80.
To put this in context, the trade weighted US dollar has risen by roughly +11% over the past year. This typically translates to a -$15-20 headwind for index level earnings. We believe this headwind is reflected in our top-down estimate for next year at $215, but not into the bottom-up consensus number of $239. Further, we learned during the Q2 reporting period that other macro sentiment shifts can impact trading per the S&P 500’s mid-June to mid-August rally even as commentary on strong dollar effects were common.
Third, we must recognize that not all sectors will have the same dollar sensitivity. In particular, we would focus on Consumer Discretionary and Information Technology as areas of more acute dollar sensitivity. Materials and Energy show high sensitivity, but we believe these regression relationships exist due to the historical connection between dollar direction and commodity price action. Said differently,
while a dollar headwind could exist for Energy names, the main driver will still be oil prices. It is important to recognize that there can be supply chain effects to this currency discussion. Components can move around the globe before finding their way to a finished good. Also, a stronger US dollar may provide some companies COGS relief via an implicit cost benefit.
Essentially, dollar appreciation should create a headwind for index EPS but it is likely to be a more sector or, in actually, a stock specific driver, should a stronger dollar manifest alongside severely weakening foreign market trends. We believe the recent dollar strength is well recognized in our out-year estimates driven by the greenback’s inclusion in our forecasting models. Bottom-up consensus estimates will likely have to come in.
Changing Performance Relationships
Herein we move on to consider the dollar relationship to performance, both absolute and relative. The key to our analysis is not assuming long-term dollar correlations between equities and the dollar are stagnant over time.
First, we recognize that for most of the post-Tech Bubble era the dollar has been negatively correlated to the direction of the S&P 500. However, there have been instances where stocks and the currency have moved in lockstep. One example includes the Financial Crisis where initially both stocks and the dollar fell as the US was viewed as the epicenter of banking and housing concerns.
Second, sensitivity, or beta, to the dollar has to be considered alongside directional relationships. Currently, the S&P 500’s beta to the trade weighted dollar is extended in negative territory. The latest medium-term beta is not too far from the most negative levels we have seen in the past 20 years.
Third, we look for some drivers to changing correlations (Figure 7) and sensitivities (Figure 8). To us, the starting level and direction of the dollar seem to be related to changes in S&P 500 relationships. Typically, correlation and beta tend to be more negative when the dollar is rising off of low levels.
However, there is an exception, and it happens to be the current regime we are in now. US equity sensitivity to dollar moves is most severe when the dollar is rising from a high starting point.
We also need to be aware of how relationships could change if the dollar’s strength reverses. Lower correlation and beta to a high but falling dollar implies that the S&P 500 may not benefit as aggressively if the greenback trend reverses. Essentially, upside from a weaker dollar may not match the pain felt from a rising dollar.
Fourth, we consider relative performance correlations. We believe some of the near-term dollar correlations will evolve. The dollar’s correlation to S&P 500 relative to MSCI ACWI ex-US performance has moved to near zero of late. Essentially, correlated sell-offs and rallies in similar magnitudes over the past 6 months have driven an undefined relationship.
However, the US tends to outperform during a rising dollar, a relationship we believe will recouple as a meaningless or negative correlation is very rare (Figure 9).
However, the US tends to outperform during a rising dollar, a relationship we believe will recouple as a meaningless or negative correlation is very rare (Figure 9).
Small Cap relative to Large is likely most misunderstood. Many believe that a strong dollar should benefit the more domestically oriented Small Caps. However, the relative performance correlation over time implies a weaker dollar tends to be better for the small size trade. The dollar has been a key risk-on/off indicator year-to-date and currently Small Cap is being viewed as a risk-on/off relative equity trade. The Russell 2000 likely needs a softer dollar to get a more aggressive risk-on bid versus the S&P 500. We do not expect this relationship to change (Figure 11).
In conclusion, our main takeaway is that dollar impacts matter to earnings and fundamental expectations. But, a focus on what the dollar direction is telling us about global growth may matter more than quarterly translation effects. A stronger dollar, as fear of global recession grows, should align with a risk-off bias in equities. Weaker trading in the S&P 500 is likely in that instance, but US Large Cap is probably a safe haven at least relative to non-US stocks and smaller cap names.
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