The Irrepressible Greenback

After the turmoil of late summer, the fourth quarter brought welcome relief to most asset classes. Large company stocks and REITs gained just over 7 percent on the quarter, recover­ing their losses from earlier in the year and allowing those sectors to return 1.4 percent and 1.8 percent respectively for 2015.  In fact, only commodities and high yield bonds showed significant losses during the quarter, though small cap U.S. stocks, emerging market stocks, commodities and high yield bonds were all losers on the year.

The big story for 2015 was the massive rally in the U.S. dollar. The dollar gained 11.8 percent on the year, its strong­est single-year per­for­mance since the end of Bretton Woods in 1971.

The dollar rally started in August 2011, but picked up considerable steam in 2014. Since the rally began, the dollar has gained 36.4%.

Dollar strength will likely continue in 2016. Most of the conditions that sparked the dollar rally remain in place, including high U.S. interest rates relative to other major currencies. The Federal Reserve’s decision to begin raising rates while Europe and Japan continue with quantitative easing will exacerbate this interest rate differential and will likely draw capital into dollar-denominated assets.

Corporate earnings under pressure

The strong dollar affects a broad array of econo­mic factors including U.S. corporate earn­ings. Given that 40 percent of S&P 500 earn­ings come from foreign operations, we can surmise that last year’s dollar rally reduced 2015 operating earnings by 4.7 percent.  Additional factors, like falling oil prices, contributed to the year’s 5.9 percent decline in operating earnings, but the bulk of the decline came from the strong dollar.

Foreign stock returns: lost in translation

The rising dollar also hurt the returns earned by dollar-based investors in foreign markets. As the chart to the right shows, local currency returns in many markets were significantly better than those in the United States. For example, investors in Europe, excluding the U.K., earned 9.1 percent in euro terms. Unfortunately, after translating into dollars, those returns ended up being 0.1 percent.

While it is true that good investment results can be spoiled by foreign exchange losses, it is also true that a strong dollar presents some com­pelling opportunities. Now may be a very good time to use the strong dollar to begin buying assets in foreign markets.

China’s growth engine sputters

China’s push to become a global economic power was fueled primarily by exports. Its success helped it amass $4 trillion of foreign exchange reserves by 2014. While these reserves give it huge clout, they also fuel com­plaints that China has kept the yuan artificially low.

In 2005, to counter this criticism and gain greater international acceptance of the yuan, China linked the yuan to the dollar and allowed it to appre­ciate. The resulting appreciation, shown in the accom­pany­ing chart by the downward sloping red line, did nothing to slow its growth in reserves, but did reduce the competitive­ness of Chinese exports. Between 2006 and 2014, exports, as a share of GDP, fell from 35 percent to 22 percent.

For the past few years, it has been evident that China’s growth engine was sputtering. Last year, as the Fed prepared to raise interest rates, the People’s Bank of China decided to break the yuan’s link to the dollar. In August it initiated a small 1.9 percent devaluation. In December, it released a communi­que in which it said it would end the peg to the dollar, replacing it with a “floating and flexible” exchange rate regime. In other words, China will devalue the yuan—a prospect that has unnerved many holders of yuan-denomin­ated assets—including Chinese stocks.

While a full discussion of China’s new currency policy is beyond the scope of this article, some ramifications are already being felt, including a rapid drawdown of China’s foreign exchange reserves (now “only” $3.3trillion) and increased volatility in world stock markets.  These developments should not give us too much concern as long as China follows through with a more complete set of economic reforms. Its economic problems go much deeper than an overly-strong currency. Its large foreign exchange reserves give it the financial muscle to address these problems as long as it has the political will to pursue the necessary solutions.

The effects of the dollar rally will continue to be felt for many months, but are likely to be transient. While they last, investors should view downward pressure on U.S. stock prices as an opportunity to put new cash to work. We should also view the strong dollar as an opportunity to start building positions in international equities, including emerging markets, and possibly even commodities. As always, we are here to answer any questions you might have. Please call any time.


Steven Merrell CFP®, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: