What a Strong U.S. Dollar Means for Investors

Key Takeaways

• The strong dollar is driven by inflation in the United States. The U.S. Federal Reserve really was one of the first major central banks to really start tightening monetary policy in order to limit inflation.
• If there is no change to inflation, the dollar will remain strong for the foreseeable future.
• The strong dollar will cause companies that have a significant portion of their earnings coming from overseas to suffer most in their earnings.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. The U.S. dollar recently hit new two-decade highs after the Federal Reserve raised interest rates in September. Morningstar's chief U.S. market strategist Dave Sekera is here today to discuss what the strong dollar means for investors, company earnings, and stocks. Dave, let's start out talking a little bit about what's been driving the dollar's strength in 2022.

Dave Sekera: Well, there's been a number of different reasons, but first and foremost, from a fundamental point of view, I think it's because inflation in the United States, while we haven't turned the corner yet, at least has stopped going up. And the Federal Reserve here in the U.S. really was one of the first major central banks to really start tightening monetary policy in order to limit inflation. So, I think that from a fundamental point of view is one of the biggest reasons that we've seen the strength of the dollar, especially as inflation has been ramping up in the EU and the U.K.

I'd also say, from a more technical point of view, the other thing we've been seeing is that there has been a flight to safety to the U.S. dollar. So, again, while markets have been going down, both in the U.S. as well as internationally, the economic outlook globally has been pretty soft. That flight to safety has also helped push the dollar stronger.

Dziubinski: Do you expect the dollar to remain strong for the rest of this year?

Sekera Well, we don't explicitly forecast foreign exchange or the dollar in and of itself. We really stick to analyzing the fundamentals of the companies under our coverage. Now, having said that, I would say that in an environment that as long as inflation in the U.S. doesn't continue to start ramping back up and we do see inflation running hot in those other areas within the world, then yes, the dollar probably will remain strong for the foreseeable future.

Dziubinski: In a recent column that you wrote for morningstar.com, you talked a little bit about how a strong dollar can cause a threat to company earnings. Unpack that a little bit.

Sekera: Well, specifically, that's going to be for those global companies that have a lot of earnings in foreign jurisdictions, and essentially it's going to be what's called foreign-exchange currency translation, in accounting terms. Essentially that just means that when you have those earnings in a foreign currency generated overseas, when that company translates that back into U.S. dollars, for every amount of foreign currency that you have, you end up getting less dollars back in the United States. And so that will be a headwind to earnings growth for those companies.

Dziubinski: Dave, what types of companies tend to suffer the most when the dollar's strong?

Sekera: Well, again, as we mentioned earlier, it's those companies that do have a significant portion of their earnings coming from overseas. But from a fundamental point of view, more specifically, I'm also concerned about those companies that might have a mismatch between their revenue and their operating costs. For example, if their operating revenue is in U.S. dollars but then their costs would be in that foreign currency, you can see an expansion in their margins, which of course would be good for the company as the foreign currency is cheaper. Or conversely, if it's the opposite way around, and they're generating the revenue in that foreign currency, but their costs are in U.S. dollars, that then could actually impair and constrict their operating margins, which, of course, fundamentally could reduce the value of that company.

Dziubinski: Dave, how should investors be thinking about companies that may see their earnings get nicked by the strong dollar? Is this a reason to sell or are earnings disappointments that are maybe driven by that strong dollar something to sort just gloss over as long as the long-term story's good? How should they think about it?

Sekera: Well, I wouldn't say it's a reason to sell. It's certainly going to be a reason to dig in a little bit deeper and really understand how that foreign-currency translation may be impacting the fundamentals of the business of itself. So, we look at that foreign currency translation as an accounting change, which is really just going to be a one-time hit in earnings. Unless you expect that the dollar would continue to keep appreciating at a similar rate, it'll hit that one quarter, but then it really won't hit in the quarters thereafter. However, our equity analyst team, they're really looking at the underlying fundamentals of that company. They would be looking for instances that the fundamentals could change because of the difference in those foreign-exchange valuations. And if that were to actually impair the company, then yes, it could be a reason that it may be enough to push the stock down, and of course, you'd want to sell ahead of that.

Dziubinski: Lastly, Dave, are there any stocks today whose earnings may be a little vulnerable to this strong dollar but where we have faith in the long-term story and maybe they're undervalued?

Sekera: Sure. So a couple of international companies I highlight right now that we think are significantly undervalued, first would be Anheuser-Busch InBev BUD. Again, the largest beer company in the world has sales all across the globe, so they're going to have lots of different types of foreign-currency issues no matter how you look at it. But that stock, we think is significantly undervalued at this point in time. It also plays into a theme that we've talked about before, which is kind of that consumer normalization that we expect as the pandemic recedes. We think that there'll be some benefits for that company going forward as well.

The next one I would mention would be SAP SAP, a large German technology company. That one has been under pressure. That one I think has traded off over 40% year to date. So, that's trading well into undervalue territory, in our view.

Then lastly, the one that I would mention is GSK GSK, GlaxoSmithKline. That company's actually one of our healthcare team's best picks right now, and it's been under pressure for two different reasons. The first, of course, would be the foreign-currency translation, but I'd also note this is a little bit of a story stock, it does take a little bit of research and due diligence. The company's getting some lawsuits right now for one of their prior products, which was used for heartburn. Those lawsuits are claiming that it might cause cancer, so the market has really sold that stock off. Our healthcare team, they've looked at the situation, they've put together a couple of different scenarios, and they think that the amount that that stock has gone down is several times greater than any potential settlements that they think that company may have to pay out in the future.

Dziubinski: Well, Dave, thanks for your time and for your perspective today on what this strong U.S. dollar may mean for earnings, stocks, and investors. We appreciate it.

Sekera All right. Well, thank you, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.