Recent talk about increasing oil prices and a rising dollar has led to concern that the combination could be a double whammy for U.S. equities. As oil prices go up, business expenses go up. Rising expenses squeeze margins, lowering profits. A rising dollar makes U.S. exports more expensive, leading to declining revenue.
As expenses go up and revenue goes down, companies make less money. The net result, ultimately, could be lower prices for shares of stock – especially in companies that rely on exports as a significant part of their business.
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When interest rates go up that could help fuel a further rise in the dollar. Since September, the Dollar index has risen from 91 to 94.5, a rise of almost 4%. If inflation and even higher interest rates take place, the index could rise even further.
Conversely, of course, falling interest rates could deflate the dollar. There is no immediate sign that is going to happen. Inflation is increasing, and interest rates are rising. All this points to a rising dollar and lower equity prices.
As it turns out, however, the relationship between currency valuations and the stock market is complex. In truth a weak dollar does not necessarily point to a strong stock market. Since the value of the dollar is based on supply and demand, it’s important to pay attention to who is buying dollars and how many they are buying.
Foreign investors, for example, often buy U.S. dollars as a haven, especially when their native country experiences economic problems. When the U.S. economy goes into a downturn, those same investors sell their dollars.
Imports Versus Exports
If the dollar drops in value, the price of goods purchased or traded in dollars increases. So, for example, stocks in energy companies may rise when the dollar weakens. Imports become more expensive when the dollar has been devalued but foreign companies can purchase American goods at lower prices.
This helps drive exports. As exports increase, profits rise and stocks in U.S. companies become more valuable. Investors may shift cash from bonds to stocks and this (thanks to supply and demand) drives stock prices even higher.
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Not So Fast
While it’s true that a large part of corporate earnings comes from foreign sales and a strong dollar would result in a sales decline, it’s also true that a large part of expenses for many corporations comes from overseas as well. If expenses are mainly generated offshore, expenses go down when the dollar is strong (and the dollar buys more materials and labor).
Since the U.S. runs a sizable trade deficit with the rest of the world, truth is, a strong dollar is more of a net positive for the U.S. economy. That said, the trade deficit is only about 5% of GDP, so a strong dollar would not result in a huge economic boost. But it doesn’t hurt either.