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.

Emerging Markets Get “Trumped”

While Trump’s potential fiscal stimulus could boost U.S. growth, it will not be sufficient to offset the negative impact on EM from poor local fundamentals, a stronger dollar and rising Treasury yields.


From a historical perspective, firm U.S. growth has not been a panacea for EM, particularly when the latter’s domestic fundamentals are poor and commodities prices are falling. For example, EM in general and emerging Asia in particular collapsed in 1997/98 when U.S. real GDP growth was averaging 4.5% (and European growth was 3.5%). U.S. import volumes were booming at double-digit rates, but this was insufficient to circumvent the crisis in Asia.

Further, the U.S. and Europe were dominant sources of global demand in the 1990s and China was not at all an economic power. Since the turn of the century, the significance of China has grown enormously, while the importance of the U.S. and Europe with respect to global demand has fallen.

In short, an outlook for stronger U.S. growth is not a reason to turn bullish on EM. Growth prospects and fundamentals in EM have not improved. Meanwhile, a stronger U.S. dollar and rising Treasury yields will attract global capital flows and pressure commodity prices. This will leave EM current account deficit countries exposed and EM carry trades at risk of unraveling.

Trump-onomics Distilled

Trump’s signature policy proposals – fiscal stimulus, a more restrictive immigration policy and trade protectionism – are bullish for the U.S. dollar and bearish for bonds.


The Tax Policy Center estimates that Trump’s tax plan alone would increase the federal debt by $6.2 trillion over the next ten years (excluding additional interest). We doubt that Congress will approve anything close to that. Nevertheless, even if he gets one quarter of the revenue and expenditure measures that he is seeking, this would be enough to boost aggregate demand growth by 0.5-1.0% per year over the next two years.

Trump’s campaign rhetoric focused on combating illegal immigration. The pool of unemployed low-skilled workers has largely evaporated in recent years. Since illegal immigrants are generally poorly educated, stricter immigration policies would raise the wages of low-skilled workers. As such workers tend to have the highest marginal propensity to consume, this would further boost aggregate demand.

The executive branch has a lot of discretion over trade policy. The threat of punitive measures is likely to dissuade some U.S. companies from moving production abroad. On the flipside, the fear of losing access to the U.S. market might persuade some foreign companies to relocate production to the United States. Moreover, higher trade barriers would further raise real wages for low-skilled workers.

In sum, Trump’s policies could cause the U.S. economy to overheat, forcing the Fed to hike rates more aggressively.

U.S. Equities: A Premature Celebration?

U.S. equities are celebrating the election results. However, a meaningful fiscal stimulus may not come before 2018. Until then, policy uncertainty and tighter financial conditions could cap the market’s upside.


Investors believe the political regime shift will entail fiscal stimulus and a lifting in regulatory constraints that stir animal spirits and pull the U.S. economy out of its growth funk. The reality is that it is premature to make long-term assumptions. The political process could delay any meaningful fiscal stimulus until 2018.

Further, Trump’s anti-trade rhetoric and penchant for profligacy may dampen business confidence and increase policy uncertainty, causing delays in decision-making and investment. Policy uncertainty and confidence have been reliable leading indicators for valuations, and slippage would put upward pressure on the Equity Risk Premium.

Rather than get overly excited about the potential for a new fiscal spending impulse, it may be more appropriate to view the latter as truncating downside economic risks. Consequently, we still expect undervalued defensives to retake a leadership role from overvalued cyclical sectors and we also retain a domestic versus global bias.

It will be critical to monitor aggregate financial conditions. The Goldman Sachs Financial Conditions index has tentatively edged up. If corporate bond spreads, long-term yields and the U.S. dollar move much higher, financial conditions will tighten further and the odds of the broad market making further gains will diminish significantly.

U.S. Election: Outcomes & Investment Implications

Donald Trump won by stealing Democrats’ thunder in the Midwestern rust belt. He promised, as a Republican, to boost fiscal spending and reduce trade globalization, marking the country’s leftward shift on economic policy. Do not bet on checks and balances stopping him from executing his policies in the short-term. Polarization will rise despite unified government.

To access the report entitled: “U.S. Election: Outcomes And Investment Implications“, please click here.

Republicans Are Not Fiscally Responsible