The Strong Dollar And The Retiree

Co-produced with Philip Mause

The U.S. Dollar has recently undergone massive appreciation against other currencies. Its strength as measured by a commonly used metric is the highest it has been in 20 years. The move has been sudden. The dollar has appreciated some 30% against the Japanese yen in the last year and has moved up nearly 20% against the Euro and the British pound. Based on most metrics, it has still not risen to the Alpine levels it achieved in the 1980s when the Fed was raising rates aggressively to stamp out inflation, but it may be on the way to that result.

We should remember that we tend to view the world and investments through the window of nominal dollars. When we say the market is up or down, when we calculate yield, and when we look at total return, we are generally talking about these things measured in nominal dollars. For example, although the stock market has been terrible this year, an investor in Japan who converted his yen into dollars a year ago and put it into the U.S. stock market would not have done horribly bad after selling this past week and converting the dollars he obtained back into yen. Conversely, the high commodity prices we have experienced – in dollar terms – have actually been much worse for many living in other countries when measured in their own currencies.

The high dollar is a consequence of higher interest rates and – from the perspective of the Fed’s effort to reduce inflation – it is not an unwelcome consequence. A strong dollar will tend to reduce commodity prices here in the United States, it will tend to reduce the dollar-denominated prices of imports, it may induce U.S. producers to sell domestically due to their inability to sell abroad, and it will probably drive down hotel rates and the prices of other tourist related services as foreign tourists postpone increasingly expensive travel to the United States.

The strong dollar was one factor in the successful taming of inflation during the 1980s. Import competition drove down prices and domestic producers were forced to shave prices as well. The very psychology of a “strong” dollar tended to induce the public to consider saving rather than spending. It is an important weapon in the Fed’s arsenal. It is entirely possible that we are not at or even very near the top-of-dollar appreciation.

Investment Implications

Because we measure earnings and other investment metrics in nominal dollars, the strong dollar presents challenges for investors. Some impacts are obvious. U.S. companies that generate a large percentage of their income abroad will experience earnings erosion as the dollar-denominated value of that income declines. Some examples of companies that generate a large percentage of their revenue abroad are Coca-Cola (KO) (66%), Mondelez (MDLZ) (75%), and Booking Holdings (BKNG) (86%). Many corporations are likely to use – with some justification – the exchange rate situation as an “excuse” for missing earnings targets and may even state their earnings with and without exchange rate impacts. Other companies will have difficulty exporting or competing with importers – in the early 1980s the U.S. steel industry was devastated and the auto industry took a hard hit. The tourism industry may also get whacked – especially in the segments which rely upon foreign tourists. On the other hand, it is also the case that the strong dollar can create some degree of attraction for foreign (and domestic) investors who anticipate (as investors usually do) that current trends will continue and thus the dollar will appreciate further. This could create somewhat of a tailwind for U.S. securities in general as a vehicle for benefitting from this anticipated appreciation.

So – where is the best place to hide in this particular storm?

Companies whose business generates all or almost all of its revenue here in the United States and who do not face much foreign competition are probably best insulated from the impact of a strong dollar. In this regard, healthcare services, most real estate, retail, and some parts of the financial sector may be somewhat of a safe harbor from this particular risk. Investors should bear in mind that there are other dangers in the current economic environment so that home builders – who are probably not impacted very much by a strong dollar – clearly face other challenges due to high-interest rates.

The energy sector is a bit of a puzzle in this regard. In past inflation episodes, the U.S. was a large energy importer and so our balance of payments was adversely affected by high energy prices. Still, even in these episodes, the fact that we produced much of our own energy tended to lead the dollar to appreciate against the currencies of other developed economies. This time, the U.S. is a net exporter of natural gas, petroleum/refined products (we import crude and export refined products – a net result is a small number of net exports), and coal. This should make the strong dollar issue even more pronounced. The energy industry itself may face challenges due to demand destruction. However, we can be pretty confident that at least the natural gas industry will be able to sell everything it can produce either here or for export to Europe via LNG. This should make natural gas-oriented energy plays attractive.

Many of the sectors that generate high dividends fall into the protected areas. Thus, most BDCs lend almost exclusively within the U.S. The vast majority of REITs hold property almost entirely within the U.S. Midstream companies and MLPs serve the U.S. energy industry and that industry should continue to perform reasonably well due to the worldwide disruption of oil and especially natural gas markets created by the Russian invasion of Ukraine and the reaction to that aggression. The good news is that the vast majority of these companies offer high dividends and high income for retirees and those seeking for retirement. Good examples would be Enterprise Products Partners (EPD) with a yield of 7.6% and Antero Midstream (AM) with a yield of 9.1%. For those seeking immediate diversification in this sector, the CEF (closed-end fund) First Trust MLP & Energy Income Fund (FEI) with a yield of 8.2% is a good choice.

As a general matter, dividend-paying stocks and carefully selected fixed-income positions do tend to be attractive because a large part of their total return is in the form of actual current or near-term dollars that are becoming ever more valuable. Many of the stocks with little or no exposure to foreign sales or competition are also attractive dividend-paying stocks. In addition, fixed-income positions generate immediate and relatively reliable cash flow. In this regard, preferred stocks and baby bonds can be very attractive although one must be selective and aware of the potential for rising interest rates to – at least temporarily – diminish total returns (unless they are to be held to maturity). At High Dividend Opportunities, we propose a portfolio to our members of 50 carefully handpicked high-yield preferred stocks, and 20 bonds and “baby bonds”.

Investors should also be aware that the recent and very sudden appreciation of the dollar can create financial risks that may force the Fed either to take corrective measures or to slow down the pace of interest rate increases. Although it is apparently less of a problem than in the past, there is still a considerable amount of foreign sovereign and private debt that is denominated in dollars. As onerous as debt can be for us here, it is much harder for a foreign entity that generates its income or tax receipts in a foreign currency – which is becoming worth fewer and fewer dollars by the hour – to make payments of a loan denominated in dollars. In this regard, we may see some arcane financial products “blow up” or some nasty defaults emerge and it may – at least temporarily – terrorize financial markets.

The Good News – Lifestyle

If you have always wanted to travel to Europe or Japan, this is not a bad time to do so – your dollar will go much, much further than it would have a couple of years ago. This is a very good time to take international trips that are on your “bucket list.” It is also possible that you will discover bargain shopping opportunities in foreign countries. One of our authors remembers the strong dollar era in the 1980s and recalls buying most of his clothes in Europe and Canada. He even remembers seeing a prominent member of the Federal Reserve going up the gangplank on a cruise ship in Bermuda headed back to New York struggling with huge shopping bags. A friend of one author’s wife made a business out of buying used cars in Germany and then bringing them back to the U.S. for resale. And very recently, he discovered that – for the first time in ages – it was actually cheaper to buy expensive video equipment in Europe rather than from the discount shops in New York City.

Another possible opportunity that the strong dollar opens up is off-shore retirement or retiring overseas in a new country. For retirees who receive pensions, social security payments, annuities, and other income in dollars, there are parts of the world in which those dollars provide a more luxurious lifestyle than here at home. Many Americans have taken this option but careful investigation of issues of health care, property ownership issues, safety, and ease of transportation is – of course – in order. It is also the case that the strong dollar may not last forever so the purchase of a residence now – while the dollar is strong – may be advisable.

Of course, the choice to relocate is a momentous one and should not be motivated primarily by transitory changes in exchange rates. On the other hand, for those who have investigated this option and find it attractive, the timing right now is pretty good.

Conclusion

The strong dollar is likely to last a while. The Fed will not ease up until it sees at least several months of sharply reduced inflation. Our primary trading partners will all have challenging times ahead on the energy front – even if Europe replaces Russian gas, it will probably be at greater expense. On a comparative basis, at least, the U.S. economy looks strong and all of these factors could push the dollar to considerably higher levels.