The U.S. Dollar has weakened against all of the major currencies this morning following the stronger profit forecast from Citigroup. However the correction will most likely be just a hiccup in the dollar’s overall uptrend as the uncertainty about the financial sector has yet to be resolved. Over the past 6 months, the dollar has soared against all of the G10 currencies with the exception of the Japanese Yen. The primary reason for the strong demand is flight to safety into U.S. Dollars and U.S. Treasuries. Although the dollar’s strength has its advantages, the consequences are more worrisome. On Monday, McDonald’s warned that the strength of the dollar and respective weakness in other currencies could decrease first quarter revenue by at least $600 million and earnings by 7 to 9 cents a share. The dollar can continue to rally, but further strength will seriously inhibit a recovery in the U.S. economy.
Benefits of Dollar Strength
The top 3 benefits of dollar strength are:
1. Cheaper Imports
2. Lower Commodity Prices
3. Cheaper Travel
The primary advantage of a strong dollar is greater purchasing power for Americans. If the greenback rises 20 percent against the British pound, it means that traveling or buying things from the U.K. becomes 20 percent cheaper. The only problem is that Americans are not spending or traveling. On the other hand, what is helping is the global economy is the dollar’s impact on commodity prices. Since oil is priced dollars, the 25 percent rally in the U.S. dollar since July 2008 has contributed to the 68 percent decline in oil prices during the same period.
Consequences of Dollar Strength
Unfortunately, the weakness of the U.S. economy exacerbates the consequences of a strong dollar.
1. Hurts U.S. Exporters
2. Reduces the Profitability of Foreign Branches of U.S. Corporations
3. Reduces Cross Border Merger and Acquisitions
McDonald’s is not the only company to warn about weaker earnings due to foreign currency fluctuations. This morning, United Technologies announced plans to lay off 11,600 workers as a rising dollar and deteriorating economic conditions force the company to cut back. Last week, Burger King Corp and Estee Lauder also announced that their profits dropped as international sales translated into fewer dollars. To explain this further, imagine that McDonald’s sell a Big Macs in the U.K. for 2 British pounds at a GBP/USD exchange rate of 1.80. For U.S. based McDonald’s, that would mean revenue of $3.60 per Big Mac. Suppose that the British pound weakens 20 percent, bringing the GBP/USD exchange rate down to 1.44. The 2 British pounds that they charge for each Big Mac now equals revenue of only $2.88 instead of $3.60. Compound this by millions of Big Macs sold abroad and you understand how a strong dollar hurts companies like McDonald’s.
A strong dollar also negatively impacts U.S. companies selling products abroad because it reduces their competitiveness. The companies are faced with the difficult of decision of raising prices to keep margins intact or maintain their competitiveness by reducing prices and take a hit to profit - either way, it is a losing situation for U.S. exporters.
As for merger and acquisitions, a strong dollar reduces the cost for U.S. companies to takeover foreign companies but increases the cost of foreign companies buying U.S. companies. The reason why we consider it a disadvantage at this time is because M&A flow could go a long way in supporting the U.S. stock market, which even with today’s rally is down almost 25 percent year to date.
U.S. Needs a Weak Currency
What the U.S. economy really needs is a weak currency because it will keep demand domestic and help increase the profitability of U.S. corporations doing business abroad. Unfortunately until fear and uncertainty about the financial sector subsides that may not happen anytime soon. In the interim, it is important to realize that the recent strength of the U.S. dollar will contribute to the difficulties plaguing U.S. corporations and because of that, first quarter earnings could take a bigger hit than most investors would expect.