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U.S. Dollar’s ‘Extreme’ Rally Threatens To Tank Stocks And Spark ‘Major’ Market Stress In Coming Weeks

Topline

Despite soaring inflation pushing its buying power down domestically, the U.S. dollar has posted a staggering rally this year, and while that’s good news for Americans traveling abroad, Morgan Stanley on Monday warned many U.S. companies will suffer as their international businesses become less profitable—forcing many to cut earnings projections and tanking their stocks as a result.

Key Facts

Buoyed by demand for safe-haven assets as Federal Reserve policy tanks stocks, the U.S. dollar index, which tracks the price of the dollar’s price against six foreign currencies, has surged 16% over the past year—a rally that’s “about as extreme as it gets, historically speaking,” a team of Morgan Stanley analysts led by Michael Wilson wrote in a Monday note to clients.

Unfortunately for investors, such rallies “typically coincide with major financial stress in markets, a recession—or both,” the analysts write, noting a stronger dollar can deter international demand for U.S. companies, which generate some 30% of sales abroad, as they continue to grapple with inflation, unwanted inventories and weaker consumer spending.

“Ultimately, the Fed wants a meaningful economic slowdown to curtail inflation, and a stronger dollar is part of that cocktail,” the report continues, estimating that for every percentage point increase in the dollar on a yearly basis, earnings growth in the S&P 500 takes an average hit of 0.5 percentage points—meaning the dollar’s surge thus far could cut growth by about 8%.

Earnings projections have yet to decline this year despite growing fears of a recession, but they have started to flatten out, and Morgan Stanley expects companies will start cutting expectations over the next few quarters.

Regardless of whether the economy falls into a recession, Morgan Stanley projects such earnings revisions could push the S&P down to 3,400 points, implying some 14% downside from current levels of nearly 3,900.

The investment bank’s note comes the same day asset manager BlackRock released a report taking a bearish stance on stocks, warning that the Fed’s interest rate hikes will slow economic growth to a halt and that earnings estimates are currently “overly optimistic.”

Surprising Fact

The U.S. dollar’s ascent has pushed the value of the euro down to a 20-year low of $1.0045 One year ago it was worth $1.18.

Crucial Quote

“From a historical perspective, this bear market may only be about half way done,” Wilson said Monday, pointing out the current bear market has spanned only six months, whereas the median duration of historical bear markets is 12 months. “The main point for equity investors is that this dollar strength is just another reason to think earnings revisions are coming down over the next few earnings seasons.”

What To Watch For

Big banks kick off second-quarter earnings season this week, with JPMorgan and Morgan Stanley slated to report on Thursday, while BlackRock and Wells Fargo are among those slated for Friday. As the strong dollar adds to headwinds, Wilson says this earnings season “should be a negative catalyst for equities in the coming weeks.”

Key Background

Fueled by government stimulus and the war in Ukraine, prolonged levels of high inflation pushed the Fed to embark on the most aggressive economic tightening cycle in decades—crashing markets and sparking recession fears. Adding to concerns, the U.S. economy posted its worst showing since the Covid-induced recession in the first quarter, shrinking 1.6% despite expectations originally calling for 1% growth. Though stocks have rallied about 5% in recent weeks, the S&P 500 is still down nearly 20% this year, and the tech-heavy Nasdaq has plunged 28%.

Further Reading

No, We’re Not In A Recession Yet: Strong Job Market Keeping Economy Safe For Now, Goldman Says (Forbes)