The Fed has been weakening the dollar for a decade…

Interest rates are low. Quantitative easing measures, pumping hundreds of millions of dollars into the American economy, are high. The fed has, for years, been following a course of flushing the dollar down the pan.

The general explanation for this is that such a policy makes exports cheaper in the currency of the target market which will, in turn, drive the U.S. economy forward.

While corporate America has been reaping the benefits…

This has been great news for investors. But to understand exactly why it’s been such good news, it is necessary to understand what has really been driving corporate profits and how the increase has played out for investors.

The first level of increased corporate earnings has come from the deep cost cutting measures that corporate America has been undertaken. This has helped America’s biggest companies to boost dividend payments to its shareholders – even apple, the company that for so long pursued a policy of retaining profits and rewarding shareholders with capital gain – has jumped on the dividend paying bandwagon.

This part of the corporate profitability puzzle is best shown for what it is in the jobless numbers in the U.S. economy. According to the Bureau of Labor Statistics, unemployment has risen from 5.7% at the beginning of 2002 to 7.8% today. And the biggest upswing in unemployment came between October 2007 and May 2009, when it touched nearly 10%. It’s only in the last three years that it has managed to fall, during a period when, and openly declared for at least the rest of 2013, the United States has been pursuing a zero interest rate policy along with massive quantitative easing measures.

However, the effects of corporate cost cutting measures pale into insignificance when compared to the effect of the weakening dollar.

Consider this: nearly 60 per cent of all big corporate American profits are made abroad. Those profits are made in Euros, Sterling, Yuan, and Yen. Look at that dollar index chart again and compare it with the corporate profits chart below.

Corporate Profits

(figures from the Bureau of Economic Analysis)

In 2002, the dollar was worth around 1.12 in the world currency terms (let’s call that the world dollar). In other words, for every 1.12 world dollars of profit made outside the United States, when corporate America converted it back to U.S. dollars it was worth only $1.00. Now look at the situation in 2011. For every 78¢ of world dollars earned, that converts into $1.00 of profit. That’s a huge upswing in profitability. In fact, when you work it through, if world dollar earnings had stayed the same throughout the last decade, earnings of corporate America in U.S. dollar terms have received around a 40 per cent boost solely because of the weakening U.S. dollar.

Related: Why You Should Prepare For An Equity Sell Off in 2013

But now, the dollar has stopped weakening

While it lasted, the weakening dollar has benefited investors in United States’ equities. Corporate profits have taken off, dividend payments have increased, and share prices have followed suit.

But looking at the index chart once more, it is easy to see that the weakening of the dollar has stopped. We’ve hit bottom and we are about to see the dollar strengthen again. And it’s got nothing to do with how great the United States economy is.

Governments and Central Banks around the world are now in the process of weakening their own currencies. Interest rates in the U.S. cannot go any lower. It’s going to be mighty tough to offer any real and significant further boost to quantitative easing (indeed, some members of the Federal Open Market Committee are already calling for quantitative easing to stop in 2013).

The new Japanese government has been voted in on a platform of weakening the UN to boost exports. China has been threatening to devalue for some time. Europe is so indebted, and its economy so poor, that it has little option but to follow a policy of currency devaluation.

In other words, not only does the chart tell us that the dollar is about to strengthen (though, actually, a better way to state this would be other currencies are about to weaken), but so, too, do all economic fundamentals.

And when that US$ strengthening happens it’s going to be disastrous for your equity portfolio.

Related: Which Stocks will Benefit From QE3

Look back to see into the crystal ball

We were treated to a glimpse of just how bad this is going to be in 2009. With the financial crisis and its height, there was a sudden flight to the perceived safety of the U.S. dollar. The dollar rose from 70 to 87 on the dollar index in a matter of months. Expectations for corporate profits tumbled and so did the stock market, the S&P 500 from around 1550 in October 2007 to 735 at the beginning of February 2009. It’s no coincidence that the bottom of the market coincided almost exactly with the short term top of the trade weighted index of the dollar. And it’s no coincidence, either, that that top coincided with the bottom of the profitability of corporate America.

The real effects of a strengthening dollar

When the dollar strengthens against the world’s currencies, the fallout is going to be widespread:

·       Corporate profits will collapse

·       Corporate tax revenues will collapse

·       The United States budget deficit will widen

·       The United States current account deficit will widen

·       Unemployment will rise as companies look to maintain margins by further cost cutting measures

·       With unemployment rising and corporate profits falling, foreclosures will once more increase and the property market come under pressure

·       Bond prices will fall and bond yields rise, making the servicing of the United States Federal debt more expensive

·       With corporate profits falling dividends will be cut

·       Share buybacks will fall, as will merger and acquisition activity

·       The stock market will collapse

Related: Why is Gold Desirable During Times of Economic Uncertainty?

In summary

When the dollar rises to around 90 when measured against major world currencies, then corporate profits posted in U.S. dollar terms could drop by as much as 40 to 50%. As I write this, the S&P 500 Index is trading at a price to earnings ratio of around 16. When corporate profits collapse because of the strengthening dollar, if the stock market were to remain at the same level as it is today then the price to earnings ratio would see a rise to around 30 to 35. At the same time dividends will be cut, because of the drop in corporate profits, and payout rates may fall to near the interest rate achievable on a savings account.

This scenario will clearly be unsustainable. Equity markets will fall if the dollar rises by any appreciable amount.

The best trader in the world is hindsight. Right now we have the benefit of looking back on what happened in 2008/ 9, and seeing what the future may hold.

Michael Barton
Michael Barton

Michael Barton has a career of 25 years covering global financial markets. Having worked for companies large and small, trading and advising on assets from equities to derivative products, Michael now writes about the opportunities and markets that matter to investors. He contributes content to several keenly followed investment blogs and websites.