A rising dollar is positive for US small capitalisation shares
The dollar has started to rise following a period of weakness. This is positive for dollar dividend payers and US smaller companies.
Movements in the dollar can have a significant impact on your investments. This is especially true for investors based in the UK, as many of Britain’s largest companies are significant foreign currency earners and the FTSE 100 has a high weighting of commodity-related business. The US currency now appears to have ended a period of weakness and there are some clear ways to play this within your equity portfolio.
Exchange-rate movements reflect complex interactions between multiple forces and are notoriously difficult to predict. Indeed, the dollar weakness seen at the start of 2018 was a surprise to many because of the prospect of steeper interest rate rises in the US than in other developed markets. Under these circumstances, you would expect to see money flow into the US and the dollar ascending. However, currency investors may have been spooked by the twin US deficits – with concerns also surrounding the fact that US finances will probably be worsened in the future by the Trump tax giveaway.
Dollar ascending
Nevertheless, this weakness has all now started to reverse. The US dollar index, which tracks its value relative to a basket of foreign currencies, has risen by around 4% since mid-April. Of course, what really matters for an investor in the UK is the prospect for the pound against the dollar – and the interest rate differential between the US and UK implies a period of relative weakness for sterling.
Following anaemic growth in the first quarter of the year, expectations of interest rate rises from the Bank of England (BoE) have been pushed back to later in the year – or even 2019. Although there is likely to be a bounce-back in UK growth in the second quarter, the BoE will want to see a sustained run of positive economic data before pressing the button. Part of the Trump administration’s tax plan is also helping with the bullish case of the dollar – US companies repatriating cash held abroad should be supportive of the greenback in coming months. Although a lot of this money going back into the US is likely to be in dollars already, the large flows should be supportive.
The rising dollar should support the FTSE 100 because a major proportion of their earnings are in dollars. Movements in currency markets are therefore likely to flatter future profits on translation. However, perhaps a more significant impact can be seen in companies that pay dividends in dollars. These include cruise operator Carnival, InterContinental Hotels and credit checker Experian. Oil majors, with their chunky dividends, also tend to become more attractive in this environment. BP has even hinted in its most-recent earnings report that it could increase its dividend for the first time since 2014 later this year. A rising dollar, if it continues, will effectively turbocharge any dividend increase that is made. Other interesting companies with a large US exposure include equipment hire group Ashtead and catering group Compass.
Developing world negative
A strengthening US currency is usually bad for emerging markets, particularly if they have large debts denominated in dollars, such as Turkey and Argentina. This effect was clearly seen in the “taper tantrum” of 2013, which led to a significant sell-off in the world’s fledgling economies. In May of that year, the US Federal Reserve discussed its plans for its easing off on unconventional monetary policies. Dollar debt across the world’s developing economies rose 10% in 2017, according to the Bank for International Settlements, but we are probably not going to see as significant an effect as during the 2013 tantrum. The acceleration in global growth has boosted investment into these countries and commodity prices remains strong. Many of these nations tend to be net exporters of metals and other basic materials.
In the US, the ascending currency is a negative for corporate earnings at multinationals on translation into local currency. This is arguably an acute issue for the technology sector, for example Apple generates about 64% of revenues from outside the US so there will be a significant impact on dollar-reported sales and profits should this strength continue. However, the growth potential and sheer attractiveness of the technology sector could mitigate this dollar effect so it would be a punchy move to be negative on this important sector because of fluctuations in foreign exchange markets. It is more likely that the impact will be greater in sales at large manufacturing businesses, as a stronger dollar also makes exports more expensive for international buyers.
But this currency effect is not really seen in US domestically-focused companies, which should also benefit from cyclical vigour in the US economy. Investors who want to gain exposure to a rising dollar through equities could look at companies in the Russell 2000 or S&P Small Cap 600, using collective investments and exchange-traded funds. Indeed, this sector rotation has already started. Since April 16, when the dollar index turned, the S&P 500 is up just 0.7% compared with a 2.1% rise in the Russell 2000 and 1.9% gains in the Small Cap 600. This is down to the dollar.
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