Poking Holes in the Strong-Dollar Thesis

The dollar began its ascent against other major world currencies in mid-2014. The move higher was fast and furious, but the greenback ran into some resistance beginning in the middle of March. Until the last few days, it seemed like everyone thought the dollar would resume its upward trend following a short period of consolidation. So far that hasn't been the case. When everyone thinks the same thing, it's usually wrong.

In any case, there are two major reasons why the dollar rose in value. The first is that the US economy was perceived to be relatively strong compared to other developed markets (primarily Japan and Europe). The second is that the US central bank, the Federal Reserve, is much closer to tightening monetary policy whereas other central banks are just getting started with large-scale quantitative easing (QE). But the second factor is a function of the first. So in reality, the dollar's strength is simply reflective of the relative strength of the US economy.

But what if the US economy isn't as strong as everyone thinks? We've argued that our domestic economy has been highly dependent on a series of stimulants, without which the economy would not be growing much at all. At this stage of the game, following seven years of stop-gap monetary policy, we are concerned about the economy's ability to withstand the removal or reversal of some of those stimulants.

Aside from the removal of stimulus, the dollar's sharp appreciation since mid-2014 will be an additional headwind on US economic growth. We received fresh evidence of the dollar's effect in yesterday morning's trade deficit report. The trade deficit in March was the biggest it's been in more than six years as a 7.7% increase in imports far outweighed a 0.9% increase in exports. (Exports add to GDP growth, imports subtract) Most economists believe that the March trade data will result in negative economic growth when the Commerce Department reports its second iteration of 1Q GDP.

But just as the dollar has been a drag on US growth, it's been a boon to our trading partners. Currencies can be thought of equalizers or stabilizers that reduce growth in outperforming economies while lifting up underperforming economies. It's Robin Hood on a grand scale. A strengthening currency means that exporters will find it more difficult to compete, while demand for lower-priced imports will increase. As this process takes place, the gap in growth rates between the US and its trade partners should narrow over time. This is one reason the Eurozone is finding it so difficult to dig itself out of a terrible malaise. Each country does not have its own currency to devalue and act as a stimulant to economic growth.

What are the investment implications of the exchange rate volatility? Well, if you believe, as we do, that the US economy is still fragile and not on the verge of any big breakout, then you might start by taking some gains in the retail stocks that have appreciated nicely in the past few months. Retail stocks rose on the premise that US economic growth was poised to accelerate while other countries would remain very weak. Because retail stocks, generally speaking, have high relative exposure to the US economy, this was the best way to get the most for your investment buck.

But as money poured into the retail sector, valuations have become quite expensive. In many cases, retail stocks are now reflecting unrealistic domestic growth expectations. At the same time, there are tentative signs that the monetary easing in Japan, Europe and China is having some positive effect. If this is sustained, we think investment dollars will flow out of expensive retail stocks and into more multinational companies that have underperformed. We are currently seeing some opportunities in large-cap, US multi-national companies that have lagged as the dollar increased in value. In particular, we see value in these types of companies operating in the Industrial and Consumer Staples industries. We would caution, however, that this trade requires patience and a willingness to withstand some near-term volatility.

So, in summary, we do not believe that the outlook for US economic growth is as strong as the dollar's spike would suggest. The 2.0-2.5% growth rate we have been able to muster since the Great Recession has been heavily dependent on massive amounts of stimulus. We are nervous about what happens when some of that stimulus is removed. Moreover, the dollar's recent strength combined with a newfound aggressiveness by foreign central banks would seem to portend better things ahead for Europe, Japan and China. Will these economies close the gap to the US at a faster rate than the market expects? If so, a rotation into US multinationals (from US-centric companies like retailers) would seem to make sense.