Strong dollar fuels fears over US equities

Claims that US stocks are overvalued after a long boom is fuelling the debate between equity bulls and bears.

A deleveraging trend has raised fears over the effect that a higher inflation rate will have on the US central bank's interest rate decision, while sluggish consumer spending has not calmed nerves.

And a recent surge in European share prices has led some investors to turn away from the US as they spy increasing opportunities in the continent's belated surge.

This year has not started well for US equities. Up to April 9, dollar investors in US equity funds monitored by EPFR had withdrawn $60 billion from the sector. Of all global asset markets, only US money-market funds saw larger withdrawals.

According to the Bank of America-Merrill Lynch global fund manager survey this April, the shunning of US stocks represented wider concerns about equities, with a quarter of respondents seeing the asset class as overvalued. Yet 68% of respondents said the US was the most overvalued region for equities globally. They point to the fact that returns in Europe this year have outstripped those in the US: by May 20, in local currency terms, the S&P500 had made 1.9% and the MSCI Europe index 12.7%.

“Strength in the US dollar, and softer US economic data in the first quarter, has resulted in downward pressures on S&P500 earnings expectations and equity multiples,” said Pam Woo, head of US and global sector equities at BNP Paribas Investment Partners.

America’s largest firms – those in the S&P500 – rely on exports for a third of their revenue. A stronger dollar harms exporters both by reducing income from goods sold abroad – economists dub this the translation effect – and making these goods more expensive to produce compared with foreign competitors – the transaction effect. According to the US Bureau of Economic Analysis, US exports decreased 1.4% in the first quarter.

The effect of dollar strength is differentiated by size of company, with America’s multinationals faring worst. “Year-to-date lower foreign exposure for small-caps has seen US domestic companies significantly outperform US multinationals, those with more than 50% of revenues abroad,” said Woo, noting the S&P 500 had 33% exposure abroad, S&P400 (mid caps) 27% and Russell 2000 (small caps) 18%.

But taken over a year, the dollar effect described by Woo does not seem to be informing which parts of the US equity market investors are avoiding.

In the year to May 20, small-cap funds saw $36 billion in redemptions while flows to mid-cap funds suffered $6 billion in outflows. But US large-cap funds collectively took in $25 billion. Either investors aren’t convinced by Woo’s argument, or the recent shift from US equities is too small to show up next to longer-term inflows.

Dampened exports form a big part of investor fears about US stocks. Yet the key to US corporate fortunes is not exports, but domestic consumer spending, which comprises 68% of US GDP.

This has proved sluggish, growing just 0.1% in February, after declining 0.2% over the previous two months. Incomes grew 0.4%, 0.5% and 0.3% in February, January and December last year.

In the first case, consumers appear to have banked, rather than spent, the windfall they received from lower oil prices. A Visa survey in January found consumers were spending only 25% of the money they were saving at the pumps, and that was on groceries, clothing and fast food; 25% is being used to pay down debt, and the remaining half is saved.

“Households appear to have lost their appetite for debt-fuelled spending,” said Azad Zangana, an economist at Schroders in London.

A consumer preference for deleveraging affects equity markets indirectly, too, because it drives inflation and is highly influential in the Federal Reserve’s decision whether to increase rates. This will raise bond yields, which are likely to inhibit equity gains, because they make it more expensive for companies to borrow, and they make consumer debts costlier to service, which will stall spending further.

Because a key part of consumer spending is how well-off people feel, managers are concerned wage growth has not kept pace with the recovery in employment.

“Historically, today’s unemployment rate [5.4%] would be associated with wage growth of 4%”, says Alec Harper at Axa Rosenberg. But annualised wage growth in February was just 2%. The weaker link between employment and wage inflation means the US Fed is paying attention to more subtle capacity measures.

Data on job openings and hiring plans indicated firms were struggling to fill openings, noted Harry Prabandham, US deputy CIO at AXA Rosenberg.

He believes an April announcement of future wage increases by Walmart and McDonalds will set the tone for the industry in coming months.

This leaves company profits in an uncertain predicament. If wage growth stimulates consumer spending, sales will increase. But higher wages are likely to decrease company profit margins.

“S&P earnings-per-share growth [excluding energy] remains robust in the mid-single digits, and financial year 2015 S&P earnings are likely to surprise given the lowered bar,” concluded Woo. “The valuation gap between US and other developed markets, meanwhile, has narrowed relative to history.”

But the consensus among global managers favours bearishness on US equities, and investors have been voting with their feet. Redemptions from all investors in US equity funds have hit $30 billion year-to-date. Inflows to European equities, meanwhile, have been positive on all but three weeks this year, peaking during April at a cumulative $70 billion.

So far, investors favour Moldrop’s scepticism over Woo’s bullishness.

For the full feature on US equities, see the current (June) issue of AsianInvestor magazine