A recurring headline of late has been the strength of the U.S. dollar. The currency markets are somewhat difficult to understand, especially if you don’t do much international travelling. The dollar has increased about 10 percent versus other currencies, including the euro. At the beginning of the year, 1 euro could be exchanged for about $1.38. Today, that same 1 euro can only be exchanged for $1.24. You might think that is not very meaningful. In fact, the currency exchange rate may seem somewhat irrelevant if it doesn’t impact your day-to-day routine. However, the implications of a strong dollar could have profound ripple effects.
1. The strong U.S. dollar reduces the attractiveness of our exported goods. Many companies in the United States rely on selling goods and services overseas. A European company that purchases goods from the U.S. must now pay 10 percent more for the same products. In some instances, the company could buy less of the U.S.-made products.
Or, if a similar good is available from another country, they may purchase it from that country. If there is less demand for the U.S. company’s products, they may have to cut back on production and eliminate jobs. Small fluctuations in the currency can be absorbed without causing too much strain. If the situation persists or worsens, companies will have to adjust to those changing dynamics.
2. Global commodities are priced in U.S. dollars. The price of oil, gold, cotton and nearly every commodity is bought and sold in the global market using the U.S.-denominated price. Similar to the exported goods, commodities suddenly become 10 percent more expensive to purchase as well. There are a few differing opinions as to why a strong dollar leads to lower commodity prices. One of the simplest is supply and demand.
As the price increases, demand decreases and suppliers must reduce prices to a level that meets demand. An alternative reason is purchasing power. Let’s say a worker in Japan earns enough to purchase 10 ounces of silver for one day of work. For the same amount of work, he or she should be able to purchase the same quantity of silver, regardless of the exchange rate. If the Japanese yen is worth 10 percent less, the price of silver will need to decline by a similar amount so the worker may buy 10 ounces.
Regardless of the rationale, a precipitous decline in prices can be more problematic than beneficial. Initially, the decline in prices benefits any company that purchases commodities. Airlines certainly benefit from lower fuel prices, and consumers are saving money at the pump. However, the declines have caused commodity producers to slash budgets and switch from growth to survival mode.
When an oil producer decides to cancel a large project, the company contracted to construct the project cuts their budget as well. Then the company who manufactures tools and equipment for the construction company sells less products, and it ripples throughout the economy. This means lower growth and fewer jobs, which eventually means people take less vacations. So, although the airlines are saving on fuel, they are selling fewer tickets.
3. Emerging economies can be crushed by the strong dollar. In the early ’80s, a bullish U.S. dollar contributed to the Latin American debt crisis, and also impacted the Asian Tiger crisis in the late ’90s. Emerging markets typically have higher growth, but carry much higher risk to investors. When the economies are doing well, foreign investors will lend money to emerging market countries by purchasing their bonds.
They also deposit money in foreign banks, which facilitates higher lending. The reason for this is simple: Bond payments and interest rates in emerging markets are much higher than in the U.S. Why deposit cash in the U.S. and earn 0.25 percent, when you could earn 6 percent in Indonesia? With the dollar strengthening, the interest payments on any bond denominated in U.S. dollars becomes more expensive.
Additionally, the deposit in the Indonesian bank may still be earning 6 percent, but that is on Indonesian rupiahs. After converting the rupiahs to U.S. dollars, the extra interest doesn’t offset the loss from the exchange. As investors get nervous, the higher interest on emerging market debt and deposits becomes less alluring, and they flee to safety. It may start slowly, but history tells us it can quickly spiral out of control.
It becomes especially ugly for emerging market economies that produce commodities. Many emerging market countries rely on their natural resources for growth and haven’t yet developed more advanced industries. As the products of their principal industries decline in value, foreign investors remove available credit while their currency is declining against the U.S. dollar. They don’t just find it difficult to pay their debt – it is impossible.
Even if you aren’t engaged in foreign currency trades, this all comes back to haunt the U.S. First, it is estimated that by mid-2014, $3.1 trillion has been lent to emerging markets since the end of the financial crisis, according to the Bank for International Settlements’ quarterly review for December 2014. That more than doubles the estimated value of U.S. subprime mortgages in the beginning of 2007.
Secondly, even if the crisis doesn’t spiral out of control, a large portion of global growth is expected to come from emerging markets over the coming decades. The rise of the global middle class is creating billions of consumers to purchase products from diapers to televisions to vehicles. Without this growth, companies around the globe will struggle.
It all circles back to the beginning. As demand for U.S. goods and services decreases, the U.S. economy will be affected. Whether it is France or Thailand, a decline in goods purchased from the U.S. will slowly spread throughout the entire economy. If the dollar continues to strengthen, it could have a significant impact on your day-to-day routine.
Brett Carson , CFA, is the director of research for Carson Institutional Alliance where, as portfolio manager, he is directly responsible for managing several strategies, including perennial growth, long-term trend and write income. Additionally, the Omaha-based research department conducts thorough analyses of companies to identify undervalued stocks that carry attractive upside potential.
Advisory services offered through CWM, LLC, a Registered Investment Advisor. This material is for general information only and is not intended to provide specific advice or recommendations for any individual. To determine what is appropriate for you, consult a qualified professional. International and emerging market investing involves special risks such as currency fluctuations and political instability and may not be suitable for all investors.
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3 Reasons a Strong U.S. Dollar Can Hurt the Economy originally appeared on usnews.com
