During the past year, the U.S. stock market surged to a record high while the dollar posted its biggest appreciation in nearly a decade, rising by 7 percent on trade-weighted basis according to Bloomberg.
The dollar’s surge in the fourth quarter mainly reflected investor optimism about Donald Trump’s decisive election win. But a strong dollar could add to U.S. equity risks if it leads to a wider U.S. trade imbalance and Trump responds with higher tariffs.
In a previous commentary, I noted that the S&P 500 market valuation based on Robert Shiller’s cyclically adjusted price to earnings ratio is the highest since the internet boom in the late 1990s. At the same time, the real effective exchange rate for the dollar as calculated by the Bank for International Settlements is the highest since the mid-1980s (see chart below).
This combination is unusual, because stocks typically do well when a currency is cheap rather than when it is expensive. The reason is a cheap currency makes it easier for companies to compete internationally, whereas a strong currency is an impediment for exporters and domestic producers.
U.S. Competitiveness Problems in the 1980s
U.S. businesses learned this lesson during the mid-1980s, when the strong dollar undermined their competitiveness and the U.S. current account deficit swelled to a then record 3% of GDP. The dollar began to decline in early 1985 when investors realized it was contributing to a softening of the economy. In September of 1985, the Reagan administration signed the Plaza Accord with Japan and leading European countries in which they agreed to intervene in currency markets to weaken the dollar further.
The 1980s also marked the beginning of a trend in which U.S. multinationals boosted production offshore to utilize less expensive labor. Since then, the share of manufacturing in the economy has fallen from 23 percent to just over 10 percent today, and the U.S. has lost six million jobs in manufacturing since 2001, when China joined the WTO.
U.S. Companies Have Outperformed Since 2008
By comparison, U.S. companies have fared much better since the 2008 Global Financial Crisis (GFC). The U.S. economy is more productive than other industrial economies, and U.S. multinationals dominate the rankings of the world’s largest corporations. Amid this, U.S. corporate profit margins after tax and inventory value adjustments have risen steadily in the past 15 years, and they are now at all-time highs (see chart).
U.S. Profit Margins are at All-time Highs
So, why have U.S. corporations been more successful this time?
The main factor contributing to the economic outperformance is improved U.S. productivity growth associated with technological advances. In the three months ended September 2024, U.S. output per hour work was up by nearly 9% from its pre-pandemic level according to the Bureau of Labor Statistics, far outpacing that of Europe and Japan. There has also been a substantial widening in the productivity gap between the U.S. and Europe and Japan since the GFC.
The U.S. stock market has also outperformed international and developing markets considerably over this 15 year time span. An important reason is the U.S. has emerged as the technology leader of the world. The tech sector accounts for one third of the S&P 500 index compared with 7% for the euro stoxx 600 index.
How long this outperformance can last is anyone’s guess. What is evident, however, is Donald Trump’s win in the 2024 election has unleashed “animal spirits,” as many investors perceive his stance on tax cuts and deregulation will bolster the U.S. economy’s growth prospects. Consequently, the stock market rally could continue for a while longer, as it did after the 2016 election.
U.S. Equity Risks
Equity investors, nonetheless, need to weigh two risks.
One is the possibility that artificial intelligence may not generate the high earnings growth that is priced into leading tech stocks. This scenario would be akin to what happened when tech stocks soared in the second half of the 1990s as the internet took off. The tech bubble burst at the turn of this century when the high fliers were unable to meet high earnings expectations. It culminated with a 50 percent decline in the US stock market over three years, while the dollar surrendered all of its gains in the ensuing decade.
Another risk is that Trump could follow through on his tariff threats. The U.S. trade imbalance is a key metric he considers in assessing whether countries are gaming international trade. Whereas economists believe U.S. trade deficits stem from imbalances in domestic saving and investment, Trump views trade as a zero-sum game: Countries with trade surpluses are the “winners” and those with deficits are the “losers.”
In light of this, investors should closely monitor the U.S. external imbalance. The current account deficit relative to GDP has doubled from 2% to 4% since the onset of the Covid-19 pandemic (see chart). Moreover, the imbalance could widen in the next couple of years for two reasons. First, U.S. economic growth is likely to surpass that of Europe and Japan, and the U.S. has a high import propensity. Second, the dollar’s appreciation will make imports appear cheaper and exports more expensive.
Should Trump impose tariffs on China and other countries, it would likely invite retaliation from America’s trading partners. If so, the policy dispute would be more complex and last longer than what happened in the autumn of 1987, when the Reagan administration accused Germany and Japan of violating the Louvre Accord to stabilize the dollar. It culminated with the October 1987 stock market crash, which forced policymakers to patch over their differences very quickly.
Jeff Stein of the Washington Post reports that Donald Trump’s aides are exploring tariff plans that would be applied to every country – so-called “universal tariffs” –but would only cover critical imports. If implemented, they would pare back the most sweeping elements of Trump’s campaign plans but would still carry major consequences for the U.S. economy and consumers. Moreover, Trump could still go ahead with plans to boost tariffs on imports from China by up to 60% and those from Mexico and Canada by 20%.
My bottom line is that investors may view Trump’s threats as a bargaining ploy, but it would be a mistake to believe he will not follow through with them, especially if the U.S. current account deficit widens further. Therefore, investors need to have a strategy in place to protect their portfolios should a trade conflict break out.
Read the full article here
