This article explores the macroeconomic ramifications of a strong US dollar and highlights some investments which stand to benefit from the trend.

The dollar is the world’s reserve currency used in almost 90% of foreign exchange transactions, while more than 65 countries peg their currency to the US dollar.

Its strength is being driven mainly by anticipation of widening interest rate differentials as economic performance across the major regions diverge.

US ‘EXCEPTIONALISM’

The US economy continues to confound the sceptics, showing remarkable resilience in the face of tight monetary policy via higher interest rates.

This contrasts sharply with other regions like Europe and the UK which are showing signs of economic weakness which may lead to interest rate cuts sooner than in the US and put further upward pressure on the dollar.

A potential canary in the coal mine in this regard is Sweden’s Riksbank, which surprised the market by cutting official interest rates on 8 May, the first time it has done so since 2016.

A key reason for the Riksbank’s move is the interest rate sensitivity of the Swedish economy which has high levels of mortgage debt on floating rates. This means the impact from higher rates is felt relatively quickly.

The following section explores some of the wider effects of dollar strength on other economies.

A DOUBLE-EDGED SWORD

The Japanese authorities are becoming concerned by the weakness of the yen against the dollar, which tested a 30-year low on 30 April prompting talk of intervention by the Japanese MOF (Ministry of Finance) to defend the currency.

It might seem an odd thing to worry about given a weaker yen increases the competitiveness of Japanese goods sold in the US. The answer lies in the fact Japan imports most of its energy and raw materials, which are priced in dollars, to manufacture the goods it then exports.

Not only does this potentially impact profit margins at Japanese companies, but a weak yen also increases inflationary pressures in the wider economy. For many years Japan had maintained a negative interest rate policy to minimise the pain from higher interest costs on the nation’s large debts.

At the time of writing there has been no official announcement confirming foreign exchange intervention at the ¥160-dollar level, but the yen has since strengthened a few percentage points. Intervention involves using foreign exchange reserves to sell dollars and buy yen.

Japan is a special case in the sense that yen weakness has been driven, in part, by financial institutions exploiting the carry trade. This involves borrowing at a low interest rate to invest in an asset that provides a higher interest rate.

For example, until recently investors could borrow in yen at virtually zero and invest the proceeds in US Treasuries paying over 4%. There are trading fees and other costs to consider, but what is left over is profit.

The carry trade is a high-risk strategy because foreign exchange losses can quickly wipe out the interest rate spread, as investors selling yen at ¥160 to buy dollars have no doubt discovered.

PAIN IN EMERGING MARKETS

Historically, unilateral currency intervention has not had a lasting effect on medium-term exchange rates. The last time there was co-ordinated intervention by central banks was in the 1980s when a strong dollar last caused a headache for nations outside the US.

Further signs of stress related to the strength of the dollar include Indonesia’s surprise quarter of a percentage point hike in rates to 6.25% on 24 April to strengthen the rupia, and comments from Korean officials citing continued strength of the dollar against the Korean won.

Korea is Asia’s fourth-largest economy and a big exporter but like Japan it is also heavily dependent on importing raw materials which are priced in dollars.

A similar story is repeating itself across other emerging economies in Latin America and Africa. It is the speed of the dollar’s ascent against emerging currencies which is causing the angst.

Even large companies are feeling the pinch. Electronics giant Samsung Electronics (005930:KRX) was not expecting the won to fall so much according to Lee Sang-Ho, vice president at the Federation of Korean Industries, a lobby group representing the country’s biggest companies.

Adding to the cost of higher imports, companies which have borrowed money in US dollars are also feeling the pain of higher debt servicing costs, although some of the impact can be mitigated through currency hedging.

FTSE 100 DOLLAR SENSIVITY

FTSE index heavyweights in the mining and energy sectors are very sensitive to currency movements given the products they sell are almost exclusively priced in dollars.

When BP (BP.) reports its earnings in dollars they are worth a lot more to a sterling investor when the exchange rate is $1.24 than when it is $1.95 to the pound.

Investors electing to receive BP’s dividends in sterling will see a translational benefit from a stronger dollar, and because the shares are priced in pence the translational effect will inflate sterling earnings per share and reduce the price to earnings multiple, although overall the effects are small.

A similar benefit happens when a UK company priced in pence conducts a share buyback with cash flows generated in US dollars.

The UK’s largest companies may have their shares listed on the London Stock Exchange, but most are global businesses with significant operations outside the UK.

Schroder Investment Management estimates around 71% of the combined earnings of companies in the FTSE 100 index are generated overseas. 

HEADWIND FOR US FIRMS

Large multinational companies listed in the US are seeing the opposite effect from a strong dollar. Companies such as Coca-Cola Co (KO:NYSE) and McDonalds (MCD:NYSE) have bemoaned the negative translational effects on their overseas earnings over the past few quarters.

Several UK companies with a significant US presence have moved their reporting currency to dollars, including equipment hire group Ashtead (AHT) which generates around 85% of its revenue stateside.

In addition to translational effects there are operational or transactional effects. These happen where there is a currency mismatch between revenue and costs or assets and liabilities.

A good example is polymer manufacturer Victrex (VCT) which exports more than 98% of its products and imports raw materials from overseas.

The company does not disclose the proportion of total costs incurred in the UK although it provides a sensitivity table outlining the effect of a change in the pound/dollar on its profits in the annual report.

A 5% change in the pound/dollar exchange rate is estimated to affect profit by £2.7 million which equates to around 4.4% of earnings. This means a 15% increase in the dollar versus sterling could potentially increase profit by around 13% (or reduce profit if the pound is strong).

Victrex actively hedges between 75% and 100% of its projected transaction exposures 12-months forward. This reduces the maximum negative impact of a strong pound scenario.

WAYS TO PLAY DOLLAR STRENGTH

Due to its sector composition, the FTSE 100 index is one of the most sensitive indices to movements in the dollar making it an effective way to capture the benefits of dollar strength.

There are other potential benefits too. The UK market is trading at 50-year lows relative to the MSCI World Index and has the highest total yield globally according to Redwheel fund managers Ian Lance and Nick Purves.

Total yield is defined as the combined dividend yield plus share buyback yield. The UK offers a 6% yield, double the equivalent yield offered by the US according to analysts at Morgan Stanley.

There are several ETFs which efficiently track the FTSE 100 index for a low cost. The largest and cheapest is the iShares Core FTSE 100 ETF (ISF) which has over £24 billion of assets and a total expense ratio of 0.07% per year.

A more direct way to get exposure to continued dollar strength is via the Amundi Fed Funds US Dollar Cash ETF (FEDG) which tracks short-term money market interest rates in the US.

In effect, investors can capture both a higher rate of interest available on US money markets and any future appreciation of the dollar against the pound. This $223 million fund has a total expense ratio of 0.1% a year.

INDIVIDUAL STOCK PICKS

The Shares team has selected two UK companies which it believes are fundamentally attractive and stand to benefit from dollar strength.

Relx (REL)

Share price: £34.50

Market Cap: £64.9 billion

Anglo-Dutch information services company Relx (REL) generates around 60% of group revenue in dollars while only 40% of its employees are based in the US.

A strong dollar and weak pound boost the group’s US earnings when translated back into sterling-based EPS (earnings per share) and DPS (dividends per share).

Relx is a high-quality, high-return business characterised by strong recurring revenue generated though the firm’s subscription-based model.

An underappreciated aspect of the business is its potential to exploit generative AI (artificial intelligence) to analyse large datasets for its clients. The company has been investing in innovation around data analytics and AI for several years which is helping to reinforce an already strong competitive position.

The most advanced use of AI is probably in the legal division where its market leading Lexis +AI is helping lawyers to digest complex legal content and generate value-added analysis.

Meanwhile, the company’s science division gives clients access to the world’s largest platform dedicated to peer-reviewed primary scientific and medical research.

Relx continues to develop and incorporate content and value-added analytics driven by deeper insights gained through AI, which has the potential to open up new growth avenues and potentially gives the firm stronger pricing power. [MG]

IG Design (IGR:AIM) 

Share price – 201p

Market cap: £186.2 million

Another big dollar earner is IG Design (IGR:AIM), whose shares have rallied strongly over the past year but remain well below their pre-Covid peak.

The maker of everything from gift wrap and greetings cards to Christmas crackers and creative play products remains at the start of its turnaround journey under a new management team led by chief executive Pal Bal.

The fact over two-thirds of the company’s sales are now generated in the US, a legacy from unintegrated acquisitions across the pond made under previous management, should be positive for its shares which are priced in sterling, even though the company reports in dollars.

Bal is spearheading a new growth strategy centred on ‘winning with the winners’, which includes blue-chip retail customers such as Tesco (TSCO), Walmart (WMT:NYSE), Costco (COST:NASDAQ) and Dutch value chain Action, while at the same time pulling self-help levers to boost margins, simplify the business and drive greater supply chain resilience.

With a 345p price target, implying 70% upside, Liberum Capital points out IG Design’s cash pile is ‘already ahead of expectations, so surplus returns to shareholders could be the surprise over the next 12 months’. [JC]

‹ Previous2024-05-23Next ›