Tuesday, October 14, 2008

Why Strong U.S. Dollar Will Reduce U.S. Corporate Profits

One thing that will limit the likely temporary stock price recovery from last week's lows is that in the earnings reports of the coming weeks the effect of the dollar rally on the dollar value of the earnings of multinational U.S.-based companies will be apparent. Just how big the effect of that will be in this earnings season depends on to what extent companies have used futures/forwards to lock in the previous high exchange rates and how big the negative effect on earnings will be on stock prices depends on to what extent investors have factored in this effect. I have no idea what the answer to the first question is, and I am not really sure about the answer to the second question either, but considering the very negative effect of PepsiCo's earnings warning today on its stock price, it seems likely that it isn't fully factored in (although it is probably partially factored in). The effect will likely be even bigger in coming quarter as the dollar is even stronger now and as futures contracts expire and have to be renewed.

In previous earnings seasons, the profits of mayor U.S. corporations have been held up by the weak dollar which has boosted the dollar value of foreign earnings. As the euro was earlier this year up 15% year over year against the dollar, this meant that even if the euro value of the European subsidiaries of companies like Coca Cola or McDonald's were unchanged, the dollar value of that would still rise by 15%.

Now with the U.S. dollar being higher than year ago levels against almost all other currencies except the yen and the yuan and the currencies that are pegged to the U.S. dollar (such as the Hong Kong dollar and the Saudi riyal), this effect will not only vanish, but also be turned into its opposite. Now the dollar value of foreign earnings will fall even if they are unchanged or slightly up in local currency terms. The effect will be even larger for exporters whose margins will be squeezed. To some extent however the effect will be counteracted by gains for importers.

Moreover, with most foreign economies weakening, the local currency value of these earnings will probably take a hit in most cases. The combined effect of these two factors means that the dollar value of earnings from foreign subsidiaries will start falling after having previously soaring. And as domestic earnings will continue to fall, this means that overall profits will decline.


Blogger The Ror said...

I've got a question about your prediction on the dollar being strong in the short to medium term.

You posted a link with Ron Paul and Jim Rogers both suggesting that the recent flood of dollars will inevitably lead to serious inflation. I assume that means the dollar will have to fall. From my own understanding of the money supply, surely it should have fallen in the past few days (although given the extra flows of other western currencies this would not be noticed unless one looked at something more exotic).

Can you see, or suggest, at what point there would be a tipping point of dollar decline? Or do you disagree with the thesis of Paul and Rogers?

11:59 PM  
Blogger stefankarlsson said...

Well, first of all as Ron Paul pointed out, other countries inflate too, so the dollar might be strong against other currencies even if the U.S. inflates. And secondly, as I believe Rogers pointed out, we are not seeing inflation now because of the widespread liquidations and deleveraging. However, when things calm down then current policies will lead to massive inflation unless reversed (shich they will probably be slow to do).

And thirdly, and most importantly in my view, the effects of inflation are counteracted by the currency market interventions by foreign central banks. T

9:26 AM  

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