How Currencies Are Influencing the Markets

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Each day, thousands, if not millions, of factors influence market trends. These range from individual investors’ collective buy and sell decisions to whether a country’s central bank decides to buy back its own bonds.

One of the historically most influential factors on longer-term financial trends is a country’s currency, and whether it is depreciating or appreciating relative to its trading partners. For example, the U.S. dollar has been very strong relative to the Japanese yen and is near the highest levels relative to the yen in 12 years.

What does this mean for a U.S. company that is trying to compete with a Japanese business in the same industry? This year alone, the Japanese yen has declined -4.6% relative to the dollar. Therefore, if a U.S. company and a Japanese company both provide bids for a project, the client can choose the Japanese bid and pay in yen, or choose the U.S. company and pay in dollars. Obviously, if the goods and services are similar, the rational client would choose the Japanese company as the cost would be less.

Furthermore, if the yen is expected to continue to weaken, the client may choose to pay overtime and take advantage of the depreciating currency. Certainly, a Japan-based client choosing between paying in yen or dollars would almost certainly choose the Japanese company – why would they want to have to pay more in dollars?

In other words, a U.S. company trying to compete in Japan is having a very difficult time. And that is only one aspect of the currency’s influence.

Another problem with a strong U.S. dollar is that U.S. companies already doing business in Japan are getting paid in yen and then having to convert the yen into dollars. This is going to negatively impact profits as the same amount of yen are worth fewer U.S. dollars.

In response, a U.S. company has a couple of choices: Raise prices in Japan so the weaker yen is offset, or hedge the currency – which increases the cost of doing business in Japan. But raising prices reduces competitiveness and slows sales – somewhat of a “Morton’s Fork,” not an enticing proposition either way.

The bottom line is that U.S. companies doing business globally are facing headwinds due to the strength of the U.S. dollar. The profit weakness that resulted from the dollar’s strength was especially evident during the first quarter’s earnings releases. The dollar-based profits of companies from Procter and Gamble to McDonald’s were reduced substantially due to the translation of yen profits into dollars.

And it wasn’t just the yen. The euro is off 8.1% this year (through 6-5-2015). So now, U.S. companies are battling against Japanese and European companies that have a distinct pricing advantage. In fact, South Korea, Canada and China are joining the party and lowering rates – causing their currencies to decline versus the dollar.

It is expected that the U.S. dollar will continue to strengthen, especially if the Fed decides to start increasing interest rates while other countries’ central banks remain highly accommodative. This is one of the dilemmas facing the FOMC – do they want to put U.S. companies at even more of a disadvantage just so they can raise rates to allow them room to lower them in the event of another bout of economic weakness?

Probably not. This is why we believe the Fed rate hike cycle will be slow and deliberate. In fact, the best scenario would be for the Fed to wait for other countries to begin ending their quantitative easing measures so that their currencies will start to strengthen as well. It would then be a more even playing field.

Bottom line: A strong dollar is OK, but a too-strong dollar is very negative for U.S. competitiveness and profits. We think the Fed is aware of this and are considering the ramifications. As an aside, we are also hearing rumblings that Congress is becoming more irate with other countries intentionally depreciating their currencies to gain a global pricing advantage. The problem is, the U.S. has used the same tactics in the past with regard to QE – it’s hard to point the finger when our central bank’s actions are part of the problem.

With regard to our investment outlook, if the U.S. dollar does start to weaken relative to the yen and euro (which it has very recently), it may very well provide a bullish surprise causing U.S. companies, and markets, to gain ground.

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