Mike Wilson: U.S. Dollar Strength vs. Earnings Growth

While stocks have recently rallied, the strength of the U.S. dollar has risen sharply over the past year, presenting a major potential headwind for equities in the coming earnings season.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, July 11th, at 11 a.m. in New York. 

One of the more popular views over the past decade has been the eventual decline of the U.S. dollar. After all, with the Fed printing so many dollars since the global financial crisis and then doubling down during the COVID pandemic, this idea has merit. However, after the great financial crisis, these printed dollars never made it into the real economy, as they were simply used to patch up broken balance sheets from the housing bust. Therefore, money supply never got out of hand. In fact, during the entire period after the Fed first embarked on quantitative easing in November 2008 through the end of the cycle in March of 2020, money supply growth averaged only 6%, right in line with the long term trend of money supply and nominal GDP growth. As a result, the U.S. dollar maintained its reserve currency status and actually rose 40% during that decade. 

However, as we pointed out back in April of 2020, the stimulus provided during COVID was very different. At the time, we suggested that the coordinated fiscal and monetary policy was unprecedented. The result is that money supply growth exploded and since February 2020 has averaged 17%, or three times a long term trend, a truly unprecedented outcome that left us with much more inflation than what was desired. Now, with the Fed reversing course so quickly and the checks having stopped long ago, money supply growth has fallen all the way back to its long term trend of just 6%. Given the projected path for rate hikes and quantitative tightening, money supply growth is likely to fall even further, and the dollar is unlikely to show any signs of decline until the Fed pivots. Such a pivot seems unlikely any time soon, especially after last week's strong jobs report. 

So why does this matter so much for stocks? Based on the extreme rally so far this year, the U.S. dollar is now up 16% year over year. This is about as extreme as it gets historically speaking and unfortunately it typically coincides with financial stress on markets, a recession or both. For stocks the stronger dollar is also going to be a major headwind to earnings for many large multinationals. This could not be coming at a worse time as companies are already struggling with margin pressure from cost inflation, higher or unwanted inventories and slower demand. The simple math on S&P 500 earnings from currency is that for every percentage point increase in the dollar on a year over year basis, it's approximately a 0.5 hit to earnings per share growth. Of course, things can change quickly, but it doesn't seem likely until the path of inflation slows enough to warrant a Fed pivot. 

The main point for equity investors is that this dollar strength is just another reason to think earnings revisions are coming down over the next few earnings seasons. Therefore, the recent rally is likely to fizzle out before too long. 

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