The US Dollar has risen for 12 straight weeks - gaining over 8% against major worlde currencies since June - and while talking heads proclaim the cleanest-dirty-shirt belief in "king dollar," as Reuters notes, it could pose a triple threat to US companies' earnings: driving up the costs of doing business overseas, suppressing the value of non-US sales and, perhaps most worryingly, signaling weak international demand. While the historical relationship between the dollar and the S&P 500 has been inconsistent (though some sectors are highly correlated), Barclays fears translation effects could reduce revenues and cause estimates for Q3 to be missed (even as they are marked down dramatically). Crucially, Barclays warns dollar strength is important because it is a symptom of decelerating international economic growth and they reiterate their unchanged 1975 year-end target for the S&P.
As a group the S&P generates around half its revenue from international markets, and as Reuters notes, [8] the forward impact of this potential USD strength (foreign weakness) is anything but priced in...
...while investors and analysts have begun to figure in the negative effects of a fast-strengthening dollar with regard to the approaching third-quarter reporting period, the risk to the fourth quarter and 2015 remains largely unaccounted for.
For instance, third-quarter profit-growth expectations for S&P 500 companies have fallen back to 6.4 percent from about 11 percent two months ago, Thomson Reuters data showed.
By contrast, the fourth-quarter growth forecast is down just slightly, to 11.1 percent from a July 1 forecast of 12.0 percent. And profit-growth estimates for 2015 have actually increased in that time from 11.5 percent to 12.4 percent.
[9]
"If you try and extrapolate out to the fourth quarter and how much that currency effect is going to be, your guidance is probably going to come down for a good slug of the multinationals on the S&P," said Art Hogan, chief market strategist at Wunderlich Securities in New York.
But as Barclays notes,
The historical relationship between the dollar and the S&P 500 has not been consistent. A constant relationship between the direction of the U.S. dollar and the S&P 500 cannot be established. In fact, over the last 20 years they have moved together, moved in opposite directions, and have been unrelated.
[10]
This is confirmed by correlation data.
[11]
Still, translation effects could reduce revenue growth and cause estimates to be missed. Companies in the S&P 500 have become more internationally exposed, with foreign sales now exceeding 30% of sales. This amplifies the implications of translation, which is the accounting process of converting foreign sales back to U.S. dollars. Translation can give the appearance of weaker revenue growth when the dollar is appreciating and often leads to revenue and even EPS misses against consensus estimates. Translation could curtail revenue growth by 150bp in 2015 if our FX team’s forecasts are realized. Estimates have not yet been adjusted.
[12]
While the S&P 500 is not correlated to the dollar, some sectors are. The sectors that have the highest proportion of sales coming from outside the U.S. are information technology, materials, energy, and industrials. Among these, only the energy and materials sectors have statistically significant negative correlation to the USD. We attribute this to the dollar’s link to commodity prices.
[13]
By our calculations, a 5% increase in the USD will lead to a revenue headwind of 3% for the technology sector and 2.5% for the materials sector. Most other sectors would experience a headwind of 1-2% while telecom and utilities would be largely unaffected.
Conclusion – it is the root cause of dollar strength that is most important
While the S&P 500 may not be correlated to the dollar and translation may be dismissed as accounting, dollar strength is important, in our opinion, because it is a symptom of decelerating international economic growth. This is particularly true for Europe, which is the second largest market for S&P 500 companies. European growth has continued to slow and our 2014 GDP estimate is now just 0.7%. In addition, deflation remains a concern, with recent inflation readings of just 0.5% and long-term expectations falling below 2%. Outside of Europe, China has slowed, Japan is growing at just 1.1%, and Brazil is grappling with recession.
[14]
For the S&P 500, which derives upwards of 30% of sales from outside the U.S., decelerating international growth is surely a risk. We are reiterating our 2014 price target of 1975.
