On the earnings front, roughly 30% of S&P500 revenues come from overseas and so far in the first-quarter earnings season, a 2.8% year-over-year increase in the value of the dollar has contributed to the lowest percentage of positive earnings surprises seen in seven quarters. Moreover, if the exchange rate were to remain unchanged for the rest of the quarter, it would be up roughly 6.7% year-over-year, applying a significant drag to both revenues and earnings going forward.
So where does the dollar go from here?
The most imponderable question, of course, is geopolitics and a worsening of the conflict in Ukraine or some other geopolitical issue could cause a renewed capital flight to the dollar.
However, in other respects, economic forces should push the dollar lower.
Last week’s negative GDP print for the first quarter served as a reminder that the U.S. economy is downshifting to a lower pace of economic growth. Moreover, because this weakness occurred in a quarter with fast-growing employment, productivity slumped in the first quarter. Indeed, output per worker over the past two and a quarter years is now up just 1.4% annualized, compared to 0.9% in the prior decade. While this still implies a one-time upshift in productivity, it tends to undercut the idea that the pandemic has induced a higher growth path for productivity going forward. All of this suggests that the U.S. economic growth lead over our major trading partners should fade in the year ahead.
Second, while the Federal Reserve has been ratcheting up its hawkish rhetoric on interest rates in recent months, it will likely begin to recognize the danger of a too-aggressive monetary policy when fading fiscal stimulus and a high dollar are both already applying the brakes to the economy. While we expect the Fed to raise the federal funds rate by 0.50% this week and announce a program to reduce their balance sheet, Chairman Powell is likely, at some stage soon, to emphasize that the Fed would be willing to slow its tightening if inflation eases and economic growth shows signs of slowing too much.
Finally, the trade deficit itself will exert downward pressure on the dollar as it implies a net excess of those who have to sell dollars and buy foreign currency to complete trade transactions. This would, of course, be greatly amplified if U.S. investors are tempted to diversify their holdings by buying foreign financial assets.
The direction of the dollar is, as always, very difficult to forecast in the short run. However, in the long run, these economic forces should prevail, pushing the greenback down. This would enhance the return on international equities and this, combined with significantly lower valuations overseas, adds to the case for increasing international stock allocations in 2022 despite a world of worries.
David Kelly is chief global strategist at JPMorgan Funds.