Another earnings season is upon us, and, with it, another round of hand wringing and qualms of despair from stock analysts the world over, as they pontificate the next disaster in the making. Yes, stock analysts are worrywarts, and, since forex markets are highly correlated with the movements of stocks, then we, too, by association alone are also ones prone to anxiety and stewing over what might occur if thus and so come true. Since old Man Winter was especially harsh last quarter, the latest fear on the street is that first quarter earnings will suffer, thereby leading to two straight quarterly declines.
A new phrase, “Earnings Recession”, seems to be taking hold in the latest raft of market reviews. It is, drawn from the economic definition of a recession, that being where two straight quarters of GDP growth were negative. Earnings growth during the last quarter of 2014 declined, due primarily to the enormous rise in the strength of the Almighty Dollar. Combine more strength in the greenback with a horrendous winter, and you have a recipe for a an earnings recession. Economists are not so sure that the dread is justifiable, but perception drives the stock market, and negativity reigns at present.
Since the entities that comprise the S&P 500 derive nearly half of their revenue from overseas operations, then it is easy to logically argue that a strengthening Dollar will cause all kinds of harm on the bottom line. Yes, Treasury departments are supposed to hedge against risks like these, but there is only so much you can do when the dollar appreciates by nearly 28% over three quarters. Hedging is based on estimates of capital flows over time, and these can naturally change in nature, the reason why hedgers must continually update their strategies.
The process is not free, either. It is much like insurance. You pay a premium to ensure against a risk, typically done via an option, so that if the market moves in your favor, you can profit from the move. If one does it correctly, then you currency match foreign asset and liability values, together with revenue and expense items. You are then left with net earnings, which must eventually be stated in dollars, if you are an S&P 500 company. Foreign operations may be half of revenues, but lately, their profit contributions have been more like 80 to 90% of the take, since U.S. operations have been flat lining.
The problem is then to hedge a projected earnings stream, but, by definition, to do this is to speculate, and most all Treasury Policies condemn speculation. There are roundabout ways to accomplish this task, but the complexity involved causes more risk than the hedge itself. The net conclusion made by worried stock analysts, however, is that earnings can only suffer. There is no upside in this state of affairs. From their point of view, the Almighty Dollar will have its due, and the tab is due now. Corporate CEOs have also been warning about this slow down in their quarterly guidance statements, so this news is not new news. This “guidance” has been around for a few quarters now.
Are other storm clouds forming that suggest a similar conclusion?
Market analysts were certain that the dreaded correction would occur last week, but it never materialized. Non-Farm Payroll data were excruciatingly off the mark, but the market took the news in stride, accepting that the winter weather had been bad, as it had been a year earlier. The latest “shrug” has also been explained as the market no longer being impressed with short-term economic data. It is irrelevant in the long term and should be interpreted as only the natural perturbations of wave-driven market activity.
So what about this week? The press pundits have already grabbed onto the “earnings recession” theme. It is difficult to spot and article or talking head on financial news channels that is not spouting the term and crying that the sky really is falling this time around. If this message is repeated long enough, sooner or later it will be correct, but the current bull market, a record now in the books, just keeps on rolling along like Ol’ Man River, despite a continual stream of contrary opinions.
In addition to earnings releases, there is an abundance of economic news forthcoming this week. While there was a mixture of the good, the bad, and the ugly last week, this week will titillate even the most sanguine analyst out there. Retail sales, building permits, Michigan sentiment charts, the Fed’s “Beige Book”, initial jobless claims, inflation data, crude oil inventories, and, of course, earnings statements that will get most of the attention. Trade exports in China have already slipped, so the race is on.
It is difficult to amass readers or viewers these days without sensationalism, and so expect the theme to quickly shift to the possibility of an “earnings recession”. You may actually see this chart proffered up on occasion as evidence that doom is imminent:
The chart is not as straightforward as you might think. It attempts to present how analyst estimates have historically started out as overly optimistic for a year that is two years out, but as time passes, the actual figures have come in roughly 5 to 10% lower. Such was the case from 2012 through 2014, but predictions for 2015 suddenly took a nosedive, as noted by the near-vertical red line drop in the chart. This new-founded pessimism has been driven by the dollar’s rebirth and the suspicion that the record bull market would come crashing to an end, as soon as the Fed began its rate increase.
But, so much for conventional wisdom; for every doomsday scenario and chart, there is a corresponding scenario and chart that states the opposite conclusion. Uncertainty makes for a strange bedfellow, but some are calling it the new normal. Again, eye-opening metaphors may sell papers and draw Internet page views, but the simple truth is that everyone is playing a waiting game at the moment. Markets are in range mode, but itching to take off in one direction or another. Divergence in monetary policy still rules, and the Fed is still expected to act, perhaps in September, with its first rate hike.
A few optimists have noted that the historical record is quite clear as to what to expect once rate hikes become a reality. Per one report, “The problems with the economy and the stock market don't start with the first rate hike, but rather the last one. The stock market typically rolls over in less than a year and the economy shifts to recession three to four months after that - but dating the process from the first rate hike to the start of the recession is three years, on average.” If you buy into this argument, then the rally could last another year, and bad times would not arrive until 2018.
What are the implications for forex traders?
Uncertainty can be a good thing for traders, since it leads to greater fluctuations on a daily basis and more opportunities for quick in-and-out gains. As in golf, however, one must stay focused and avoid a high score that can result from a single unexpected swing. Many believe that a strong dollar is here to stay for several reasons, and that the stage is set for more dollar appreciation, but how much and for what period of time?
Three reasons are often cited. Much has been written about monetary policy divergence. More can be expected, since it is believed that the Fed will follow through with more rate hikes as inflation reappears. U.S. credit has been exploding, as well, especially in emerging market countries. Loan repayments will create a sustained demand for the Dollar that can only help with further appreciation. Lastly, the USD is well treasured as a safe haven when chaos rules the financial markets, and no one doubts at this juncture that a future downturn will be chaotic.
As for how much and when, the following chart was prepared by analysts and includes a Deutsche Bank) USD index forecast for 2015, as noted by the red diamond. This analysis, however, only covers a few wave periods, and the potential upswing this time around could mirror the experience back in the eighties, when the peak pushed well past the indicated 20% bands (note the dashed oval in black). Timing may be an issue, but an up tick in appreciation still seems to be secure, without much doubt or opposition from the global economic community.
Concluding Remarks
If an “earnings recession” materializes and stock market valuations fall, then it is an easy conclusion to make that the Dollar will rise in value. If experts are so certain that King Dollar will ascend a higher throne, does this forecast mean that stocks will tank, another way of saying the same thing? The historical record is rife with keen examples that make one want to believe that the past is good indicator of the future, but we know this to be a false assumption on many occasions. The rapidity of the Dollar’s rise may also have unforeseen consequences, as well, as noted in a recent March “World Outlook”:
“The US dollar has risen since last summer against the major currencies at the fastest paces on record, up 21%. Compared to a typical dollar cycle that spans from 20% below to 20% above fair value over 6-7 years, we have seen 3 years of appreciation packed into 9 months. Current levels put the dollar 10% above fair value and 3/4 of the way through a typical cycle.”
In other words, we are in uncharted territory. Expect the unexpected, and be ready to react in a moment’s notice. When the jolt comes, be prepared for a wild ride!
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.
by Tom Cleveland