Editor's note: This was originally published on RealMoney earlier this week. It is being republished (and updated) as a bonus for TheStreet.com readers.
How the dollar fares is of paramount importance to all investors and consumers. It impacts the level of profits generated by our large multinational firms, it affects oil and gasoline prices, and it can also affect interest rates.
Since this was first published, the U.S. dollar appears to have reached a peak, and may be set to reverse course.
-- David Sterman, Nov. 1, 2008
Catch the Surging Dollar When It Plateaus
Prior to the credit crisis, our currency had looked undervalued against the euro, the British pound and the Australian dollar. Not anymore. Measured against a basket of major currencies on a trade-weighted basis, the dollar surged more than 15% in the last three months (and more than 25% against the euro), before topping out on Monday.
The driving force behind the dollar: A number of countries had unhedged liabilities in dollar-denominated bonds, and as they scrambled to meet obligations, they bought dollars on the open market.
The dollar's rise was bad news for any U.S. exporters that got an ephemeral boost from the sagging dollar over the last few years. Despite a recent pullback this week, the dollar still looks strong. That's good news for companies looking to acquire trans-Atlantic rivals, or anyone looking to take a vacation in Europe, Mexico or Australia. But one should move quickly, as the dollar could start to backtrack again in 2009.
You knew something was amiss when the dollar rallied just before the
announced another 50-basis-point rate cut. In normal times, currencies weaken in the face of imminent rate cuts. Moreover, currencies typically weaken when a country's central bank cranks up the printing press and mints more currency.
But the recent "flight to quality" overwhelmed those factors as investors would rather keep their money in a currency that has a long and strong track record. Make no mistake, the euro is not yet perceived as an inviolable currency, especially as noises have emerged that some E.U. members are feeling shackled by continent-wide policies that favor the fiscally stable (Germany) over the fiscally unsound (Greece, Portugal, Italy, etc.).
Those countries are paying increasingly higher borrowing costs, and a decision to flee the E.U. is not inconceivable, especially if the current economic slowdown weakens. That would be bad news for the euro, though one could argue that if you take away the more poorly managed economies in southern Europe, the remaining stronger players would be perceived as a long-term sentiment boost for the quickly falling currency.
But when you strip out the near-term drivers, all signs point to an eventual sharp downdraft in the dollar. For starters, our budget deficits for fiscal 2008 and 2009 appear to be at record levels (on a non-inflation-adjusted basis).
Our national debt, which stood at 35% of GDP in 2001, now stands at 50% and looks headed toward the 55% mark within a few years. At some point, our creditors will either demand higher interest rates on our bonds or simply stop buying them altogether. Either way, reduced interest in our debt would lead to higher rates and a devalued currency.
In addition, the recent melt-up in the dollar is likely to bring renewed pain to our nation's export-oriented manufacturers. So the political pressure will build to move away from a "strong dollar" policy, which has been the stated goal of virtually every presidential administration. Nobody wants to see a sharp plunge in the dollar, but an orderly devaluation is crucial to our nation's long-term competiveness.
Lastly, pressure on the dollar will come simply from relative growth rates. Even though the current crisis will impede growth in places such as China, India and Brazil, those countries are still poised to grow at more robust rates over the long term. And global investors will chase higher returns in those markets, exiting their overweighted positions in dollar-denominated assets.
So what are the implications?
If I am correct that the dollar could hold its ground in the near term and materially weaken over the long term, then you can look to several investable themes.
First, assume that current consensus estimates for export-oriented business are still too high for the current quarter and for 2009. If you own a company that does a substantial amount of business in Europe (such as
Procter & Gamble
, each of which derives nearly half of their sales in Europe), the recent 25%-plus plunge in the euro should be fully factored into your earnings models. Unfortunately, many analysts that follow multinationals have not yet sufficiently lowered their profit forecasts to account for this profit headwind.
Second, when you are looking to step back into equities and feel that the depth of the expected global recession has been fully priced in, you may want to add exposure in countries that have taken an especially hard beating on the currency front.
The BRIC countries (Brazil, Russia, India and China) have all seen their stock markets fall at least 60% this year in dollar-denominated terms. Even if stocks in those countries are slow to rebound, a turnaround in their currencies would yield profits to your portfolio.
This is not a suggestion to plunge headlong into these BRIC markets, but it is clear that the flight to the dollar has created even more compelling valuations in the context of long-term growth rates.
As noted earlier, the dollar may well hold its own in the near-term as this crisis plays out. But you should be prepared to strike when the dollar appears to finally plateau.
The dollar has been getting stronger (for now), even though a range of factors should be weakening it, but it remains in a long-term secular bear trend, and appears likely to continue its downward trajectory in 2009.
The original version of this was published on
on Oct. 27, 2008. For more information about subscribing to RealMoney, please click here.
David Sterman has been an equity analyst and financial journalist for 15 years, most recently serving as Director of Research at Jesup & Lamont Securities.