U.S. Trade: Shortchanged by a Strong Dollar?

The dollar certainly has put on a show of late. Over the last six months, it has gained some 13% against the yen, 21% against the euro, and 12% against the world when weighting various currencies according to their importance in U.S. trade.1 Some believe these gains confer bragging rights for Americans. The investment community has shown more concern than anything else. It fears that the appreciation will price out U.S. exports from global markets and so threaten the U.S. economy’s manufacturing renaissance. There also is a concern that a higher-priced dollar will detract from the translation of foreign earnings for those firms that have major overseas operations. These are legitimate concerns, but they may easily be overstated.

The Translation Effect
The translation effect is mostly a matter of bookkeeping. A firm with a major operation in, say, Europe, makes that part of its earnings in euros. To produce a consolidated earnings statement in U.S. dollars, it must translate those euro earnings into dollars, even if it never actually converts the money. The stronger the dollar, the less these earnings will count in dollar terms, making the consolidated earnings look weaker than otherwise. Because the Wall Street analytical community often fails to fully account for this effect, it can surprise investors when earnings are announced. But there is seldom much impact on the U.S. economy or even the real performance of the company in question.

For one thing, the shortfall in dollar sales only occurs in the quarter in which the dollar appreciates. If the dollar then retains its new, higher level, the dollar level of the following quarter’s sales may remain lower than before the dollar appreciated, but the earnings decline does not recur. For the translation effect to do further damage, the dollar would have to appreciate quarter after quarter. This translation effect hits exporters less than companies with ongoing operations overseas. Exporters typically write their contracts in dollars. A rise in the dollar may affect sales (a matter discussed in the next section), but there is no translation effect except in those very rare instances when the trade contract is written in a depreciating foreign currency.

Even among the firms that have large overseas operations, the impact, particularly on the U.S. economy, is usually small. Some of these firms are so entrenched in those foreign markets that they do all their sourcing and production there, as well as the sales. Many, because of the United States’ virtually unique corporate tax code, have no intention of ever repatriating the earnings from such operations. In such cases, the currency effect truly is just a matter of bookkeeping. The impact on U.S. economic activity is next to nothing because so little of the production has roots in the domestic economy. The firm itself has no reason to react in any substantive way, or even change what it is doing at all, for that matter. With costs and revenues fully denominated in a foreign currency, the dollar only matters in a consolidated statement, not in the underlying profitability of the overseas operation.

There are, however, some firms that do supply their overseas effort with materials produced in the United States. The dollar’s appreciation in such a case could raise costs to the operation and, accordingly, reduce its profitability, thereby enlarging the effect beyond one of bookkeeping. Of course, that increased cost may prompt management to source elsewhere than in the United States, in which case the firm could protect the overseas operation’s profitability, but do so only at the expense of reduced economic activity in the domestic economy.

Besides these effects, the dollar’s rise, which has pushed up the price of U.S.-based production to the rest of the world and reduced foreign prices to Americans, will adversely affect the country’s balance of trade and, by implication, the overall economy. That effect is already evident. Exports growth has slowed. After rising 4.0% during 2013, total exports of goods and services from the United States have expanded by only 1.4% this past year. Imports have accelerated. After expanding a mere 1.1% in 2013, they jumped 3.4% this past year. The balance of imports and exports has inevitably deteriorated from an annualized deficit of $400 billion at the end of 2013, down from a deficit of more than $506 billion at the close of the prior year, to an annualized deficit of more than $512 billion recently, giving up more than all the gains of 2013.2

The deterioration, however, was highly inconsistent across industries. Because higher-value-added products are less price sensitive, they have suffered less from currency swings than lower-value-added, commodity-like products, which are more easily sourced elsewhere and so are much more sensitive to the price effects of the dollar’s recent rise. This distinction clearly is evident in the classic divide between goods and services.

Fully half this country’s service exports and slightly more than half of its imports lie in sophisticated, less price-sensitive areas such as financial and other business services, telecommunications, and licensing fees for intellectual capital. Accordingly, service exports have hardly slowed at all, despite the dollar’s rise, growing 3.1% in the past year, a barely noticeable deceleration from the 3.2% expansion in 2013. Imports showed a similar insensitivity, accelerating hardly at all from 3.1% growth in 2013 to 3.2% during this past year.

It is a different story for trade in goods. Because so many of these are lower-value, commodity-like items, currency shifts have had a much greater impact here than in services. Goods exports overall slowed markedly from a 4.0% growth pace in 2013 to only a 1.4% pace of advance during this past year. Goods imports similarly showed a more marked acceleration in response to the price effects of the dollar’s appreciation. After growing only 0.8% in 2013, imports jumped 3.4% during the past year. The difference between high- and low-value-added items is still more evident in subsectors of U.S. trade. For example, exports of capital goods, generally a high-value item, held up well despite the dollar’s rise, gaining 3.0% during the past year, while exports of industrial supplies, generally lower-value, more commodity-like items, suffered a decline of 0.4%. Excluding the special case of crude oil and other petroleum products, exports of this subgroup actually dropped a sharp 3.3%. The immense detail of other product sectors and subsectors, though too much to go through here, also testifies to the greater sensitivity of lower-value-added products in both imports and exports and the relative insensitivity of higher-value items to currency shifts.

Looking Forward
To be sure, imports and exports last year responded to more than just the dollar’s rise. Still, the consistency of the pattern signals what to expect in the future as the dollar continues to make gains. Especially as the Federal Reserve likely will raise interest rates, further dollar strength should cause a faster deterioration in U.S. trade, as imports rise above where they would otherwise be and exports fall below where they would otherwise be. The overall effect will reinforce other factors that are already keeping this recovery historically slow, though even the combination of effects is unlikely to precipitate a recession. And because the most damage will occur among low-value products, the net effect at the margin will reinforce the ongoing shift in this country’s economic focus and the flows of investment monies toward higher value-added products and processes.

1Source: Bloomberg.
2All data hereafter from the Department of Commerce.

The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

(c) Lord Abbett

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