Monday the U.S. dollar traded slightly higher against the euro and the pound. This followed Friday’s news of a pickup in wage growth a possible signal of impending inflation. The inflation fears sent risky assets lower on the implication the Federal Reserve might raise interest rates making borrowing costlier for business.
Latest news aside, the dollar has been falling and the latest boost may be temporary or a portend of things to come, depending on how the market performs long-term. Multinational corporations like United Technologies Corp. (NYSE:UTXC), 3M Co. (NYSE:MMMD) and Johnson & Johnson (NYSE:JNJD) could be among those reaping benefits if the long-term devaluation continues.
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Weak Versus Strong Dollar
For consumers a falling dollar is bad news. For exporters it is good news. The reasons are mostly obvious. A strong dollar against foreign currency makes incoming goods cheaper. A weak dollar serves the same purpose for exporters sending product from the U.S. to other countries.
Those multinational companies mentioned above that sell goods priced in foreign currencies won’t necessarily gain the benefit of competitive pricing but when that foreign currency is converted into a weaker U.S. dollar the company gains relatively more dollars.
The impact of the value of the U.S. dollar on corporate profits depends on several factors and makes it somewhat difficult to tell whether a strong or weak dollar is better for a specific company. What is clear is that the effect of exchange rates on financial statements can be significant and depends on where goods are sold and produced and on the impact of raw material inflation.
These factors can help you as an investor determine where and how to allocate your investment funds, in this case, when the U.S. dollar is weak.
The primary currency in which a company conducts business is known as its “functional currency.” This is determined by the Financial Accounting Standards Board (FASB) in the U.S. It’s important to note that functional currency may or may not be the same as reporting currency. For example, if you invest in a company that does most of its business in the U.S. and is domiciled in the U.S. the functional and reporting currency will be the U.S. dollar.
If the same company has a subsidiary in Europe that subsidiary’s functional currency would be the euro. When the subsidiary reports results in the reporting currency (dollar) the exchange rate comes into play. In a falling (weak) dollar environment, the profit in euros, reported in dollars will show a gain (in dollars) and higher net income.
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The Product Side
How profits are reported is only part of the picture. Where products are made and where they are sold can also be impacted by the value of the dollar. When the dollar is strong, companies fare better when products are made overseas (using cheaper labor and weak foreign currencies).
When the dollar is weak, it is often better to produce (cheaply) in the U.S. and export where a strong foreign currency results in more profit. It’s a little more complicated than that in real life, however. Many low-cost provide countries produce goods that are not affected by movement in the U.S. dollar because they “peg” their currencies to the dollar. In other words, their currencies fluctuate with the dollar.