Push Back: Costs of a Rising Dollar

Numerous companies have reported that developments in the currency markets, especially the dollar's appreciation, has been an important headwind on their earnings.  The logic is compelling.  US S&P 500 earn almost 50% of their revenue from foreign markets.  Given the greenback's appreciation, those foreign earnings translate into less dollar earnings. 

However, this is all too often where the analysis stops.  Although analysts and journalists are rightfully skeptical about government claims, they seem to be much more willing to take the corporate claims at face value. 

Many observers do not appreciate the US expansion strategy.  They confuse it for the traditional export orientation.  That is most certainly not the US strategy.  US companies service foreign demand primarily through a foreign direct investment strategy.  Build local.  Sell local.    The sales by majority owned affiliates of US multinational companies outstrips US exports by a factor of more than four. 

What this means is that US corporates do not just have revenue from abroad, but they also incur costs.  Consider that they employed nearly 5.8 mln workers in 2012, according to the most recent data.  Compensation for those employees was  estimated at $455.5 bln.  These affiliates spent about $48 bln on research for example. 

The point is that the direct investment strategy generates some offsets to the revenue; natural hedges, if you will.  Sometimes that may not prove sufficient. Companies can taken on other types of hedges, besides selling the foreign currency in the forward market or via options, which is what businesses often have in mind when they discuss the impact of currencies on their earnings. 

This week, US corporates sold a record amount of euro denominated bonds.  Coca-Cola issued 8.5 bln euros in bonds yesterday.  This is the largest euro offering by a US corporate and the second largest euro corporate offering period.  Priceline, ATT and Mondelez (maker of Ritz crackers and Oreo cookies) also issued euro denominated bonds this week, raising at total of almost 15 bln euros. 

This week brings the year-to-date euro bond sales by US corporates to about 27.5 bln euros, which is roughly twice the amount for the same year ago period and the most since 2007.   There are three general motivations.  First, it diversifies the investor base.  This may be the least significant incentive.  More important, it can reduce borrowing costs.  Eurozone interest rates are considerably lower than the US.  For example, it appears that Coca-Cola paid around 75 bp to borrow euros for eight years.  Chevron sold a 7-year bond in dollars this week, paying about 2.4%.   Moreover, the cost of swapping the euros into dollar has fallen considerable.  A five-year cross currency swap costs around 32 bp per year, about half of the cost incurred in 2012. 

The third reason that may motivate these euro borrowings is that it allows a company to offset euro revenues with a euro liability.  This is to say that corporate Treasurers can and are choosing to use the financial markets and its debt management to help insulate the company's earnings from the vagaries in the currency markets.

However, the point is that these issues are not often discussed when corporates and analysts discuss how the dollar's strength impacts earnings.  Often the discussion is cast in narrow terms, locally incurred costs are not included, hedging strategies are not examined, and savings from borrowing in foreign currencies are not taken into account. 

It is true that over the past six months as the dollar has climbed the S&P 500 has lagged behind European and Japanese markets.  The S&P 500 has risen by 5.5%, while the Dow Jones Stoxx 600 has risen 13.5% and the Nikkei is up 21%.  Many observers want to claim this is because of the dollar, but they have not really tested this in a robust way.  Typically a chart of the relative equity market performance along side the dollar's performance is shown. 

This is not a rigorous test of the hypothesis.  It ignores indisputable facts, like the fact that the Bank of Japan is buying Japanese equities as part of the unprecedented aggressive expansion of its balance sheet.  The BOJ is doing this through ETFs of large cap stocks, which includes exporters.  Surely this can be another factor producing the out performance of large cap Japanese companies over small cap, not just a function of the foreign exchange market. 

The ECB introduced negative deposit rates.  It will soon buy sovereign bonds.  Yields are already negative (at the short-end of curves, though Germany is negative through seven years).  Such financial conditions likely encourage equity purchases unrelated to the exchange rate.