Dollar Strength Warrants Caution On U.S. Equities

The strong U.S. dollar is tightening global liquidity conditions, putting the post-election jump in stock prices at risk unless growth accelerates imminently.

In a closed economy driven more by consumption than investment, a strong currency can be supportive via increased purchasing power and a dampening in corporate sector input costs. But what’s good for the economy should not automatically be extrapolated through to profits. U.S. net earnings revisions fall when the dollar is strong (second panel in the above chart).

Labor costs are now on the upswing and productivity growth has deteriorated. If the economy strengthens, it may only serve to boost wage inflation. Meanwhile, a strong dollar means the U.S. will be importing deflationary pressures, undermining corporate pricing power. Rising wages and a lack of corporate pricing power will continue to squeeze profit margins.

U.S. dollar appreciation also saps growth in developing countries. Capex in emerging markets is already contracting and financial strains are flaring up again. Not only does dollar strength make U.S. companies less competitive, but they will also be selling into weaker demand growth abroad. Just under half of S&P 500 sales come from abroad.

Finally, U.S. dollar-based global financial liquidity is contracting as the greenback strengthens. If excess liquidity and low rates were previously supporting high valuations, tighter liquidity and rising rates can’t justify current multiples, especially if global growth is soft.

The bottom line is that the outlook for the broad averages has soured as a consequence of a strong dollar, rising yields and the prospect for tighter Fed policy. These dynamics augur well for domestic vs. global bias, small vs. large caps and defensive vs. cyclical sector strategies.

Read more at BCA Research

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