U.S. corporations are beginning to complain about the damage that the strong dollar is having on corporate earnings. This morning, United Technologies announced plans to lay off 11,600 workers as a rising dollar and deteriorating economic conditions forces the company to reduce costs. Yesterday, McDonald’s warned that the strength of the dollar and respective weakness in other currencies could decrease first quarter revenue by at least $600 million and earnings by 7 to 9 cents a share. Last week, Burger King Corp and Estee Lauder also announced that their profits dropped as international sales translated into fewer dollars.
A strong dollar is both good and bad, but the bad outweighs on the good especially in the current day and age when U.S. corporations are doing a lot of business abroad.
The impact of currencies on earnings is something we have discussed often on this blog. Imagine that McDonald’s sells Big Macs in the U.K. for 2 British pounds at a GBP/USD exchange rate of 1.80. For U.S. based McDonald’s, that would mean revenue of $3.60 per Big Mac. Suppose that the British pound weakens 20 percent, bringing the GBP/USD exchange rate down to 1.44. The 2 British pounds that they charge for each Big Mac now equals revenue of only $2.88 instead of $3.60. Compound this by millions of Big Macs sold abroad and you understand how a strong dollar hurts companies like McDonald’s.
U.S. Needs a Weak Currency
What the U.S. economy really needs is a weak currency because it will keep demand domestic and help increase the profitability of U.S. corporations doing business abroad. Unfortunately until fear and uncertainty about the financial sector subsides that may not happen anytime soon. In the interim, it is important to realize that the recent strength of the U.S. dollar will contribute to the difficulties plaguing U.S. corporations and because of that, first quarter earnings could take a bigger hit than most investors would expect.
On Friday, in my Daily Currency focus for FX360.com, I talked about the 3 Big Threats to the US dollar this week. One of them was a bad bank plan. This morning, Dow futures and higher yielding currencies are up sharply on news that Obama’s Administration has prepared a plan to create a bank that would absorb toxic bank assets. Here’s a recap of what I wrote on the plan and read the rest of the report for the other 2 major threats facing the US dollar.
Bad Bank Plan – There is no question that equities are still leading currencies for the time being and over the next few weeks, the Obama Administration could announce a plan to create an “aggregator bank” that would soak up the bad debt sitting on bank balance sheets. This would free up capital for the banks which would hopefully encourage lending and restore investor confidence. If Obama announces a bad bank plan, it could squeeze shorts in financial stocks and take the entire index higher. Since currencies are still moving in lockstep with equities, a rebound in stocks could help reduce risk aversion and take some of the steam out of dollar rally.
The US dollar appears to be unfazed by this morning’s mixed economic data. An improvement in consumer confidence has failed to help the dollar while the weaker news has pretty much been baked into the markets.
Christmas and New Years week is a time when traders are more focused on seeing family than making profits. It is probably truer this year than most because of the sharp volatility in the financial markets and the deep losses endured by most investors.
Third quarter GDP remained unrevised at -0.5 percent even though personal consumption slipped and core prices eased. Investors are more worried about the Q4 numbers than the Q3. The global recession and the stronger dollar could take a big bite out corporate earnings and growth.
The housing market also remains weak with new home sales falling for the fourth consecutive month and existing home sales falling by the largest amount on record. Sharp discounts on new homes is helping to slow the pace of falling demand.
The one piece of good news that we did see this morning was consumer confidence which was revised upwards in the month of December. Given that almost everyone knows someone that has been laid off, the price of gasoline is the only reason to cheer this holiday season. Prices at the pump have fallen close to 60 percent from its summer highs. For drivers, lower gas prices is like a tax cut. At a time when salaries are being frozen and bonuses are being reduced, a tax cut in the form of lower gasoline prices is welcomed with open arms.
Here is a video interview I conducted with Marketwatch talking about where the US dollar is headed in 2009:
US GDP growth has contracted but that has not stopped the equity and currency market from rallying. The GDP number was not as bad as the market had feared but what really drove the markets higher was the Federal Reserve’s new Term Asset-Backed Securities Loan Facility (TALF).
Both the outgoing and incoming Presidents are stepping on the gas and that is helping to restore investor confidence. President Elect Barack Obama has formed his Economic Team and is outlining his Economic Stimulus plan. The Bush Administration, bailed out Citigroup yesterday and has now made a colossal announcement aimed at putting a bottom in the asset market.
Their 35% increase in the Fed balance sheet represents another $800B worth of stimulus and will cause the Fed’s balance sheet to balloon to $3 trillion. For investors that have been concerned about the funding crisis, this is an even bigger reason to sell dollars.
Here is what the Fed announced minutes before the GDP number:
– New $200B facility to support ABS
– Buy up to $500B in mortgage securities backed by Fannie Mae, Freddie Mac and Ginnie Mae
– Buy up to $100B in direct obligations of housing related Government Sponsored Enterprises
– The Treasury will use $20B of TARP funds to provide credit protection to the Fed
Expect GDP Growth to Worsen
The 0.5% drop in GDP is mild when compared to past recessions and raises the risk of a sharp decline in fourth quarter GDP. Many people believe that the current downturn is the worst since the Great Depression and if that is true, we could easily see GDP fall by 4 or 5 percent in one quarter. In 2001, GDP contracted by 1.4 percent in the third quarter. In 1990, GDP fell by 3 percent in the fourth quarter and in the first quarter of 1982 GDP dropped a whopping 6.5 percent. There is no reason why the worst case scenario this time around is just a 0.5 percent contraction in GDP.
Remember That This is a Crisis of Confidence
However despite the pessimistic outlook for growth, it is important to remember that this was a crisis of confidence. So priority number one for the outgoing and incoming Presidents is to restore confidence. Since Friday they have done a good job with that if Obama outlines more plans at his speech later this morning, we could see the rally in the currency market continue. Don’t forget that the further monetary stimulus is also in the pipeline with the Fed expected to cut interest rates again next month.