Title: Amplified Uncertainties and the Superpowered Dollar: Threats to U.S. Stocks

Title: Amplified Uncertainties and the Superpowered Dollar: Threats to U.S. Stocks

Over the past year, the U.S. stock market soared to record highs while the greenback registered its biggest increase in nearly a decade, climbing by 7% in a trade-weighted basis, as reported by Bloomberg. The dollar's ascent in the final quarter was primarily driven by investor optimism following Donald Trump's landslide victory in the U.S. presidential elections. However, a robust dollar could amplify risks associated with U.S. equities if it contributes to a wider U.S. trade deficit, prompting Trump to impose higher tariffs.

In my prior analysis, I pointed out that the S&P 500 market valuation, as measured by economist Robert Shiller's cyclically adjusted price-to-earnings ratio, reached its highest levels since the internet boom of the late 1990s. Simultaneously, the Bank for International Settlements' real effective exchange rate for the dollar hit record highs since the mid-1980s. Companies tend to thrive when a currency is cheap, but the dollar's strength presents obstacles for exporters and domestic producers.

Lessons from the 1980s

American businesses learned a tough lesson during the mid-1980s when a robust dollar undermined their competitiveness, leading to a swelling U.S. current account deficit reaching a then-record 3% of GDP. The dollar started declining in early 1985 as investors recognized its contribution to a softening economy. In September 1985, the Reagan administration inked the Plaza Accord with Japan and major European nations, committing to weaken the dollar further through currency market interventions.

The 1980s heralded the onset of U.S. multinationals shifting production to less expensive labor markets, leading to a fall in the manufacturing sector's share from 23% to around 10% at present. Since 2001, when China joined the WTO, the U.S. has lost approximately six million manufacturing jobs.

U.S. Companies on the Rebound

Since the 2008 global financial crisis, U.S. corporations have enjoyed better fortunes. The U.S. economy boasts higher productivity compared to other industrial nations, and U.S. multinationals dominate the world's top corporations. U.S. corporate profit margins have risen steadily in the past 15 years, reaching all-time highs.

The primary reason behind this resurgence is enhanced U.S. productivity growth, thanks to technological advances. In the last three months of 2024, U.S. output per hour work surged almost 9% compared to its pre-pandemic levels, according to the Bureau of Labor Statistics. Europe and Japan have failed to match the U.S. in productivity growth since the financial crisis.

The U.S. stock market has outperformed international and emerging markets since 2008, attributed primarily to the U.S. being the technology leader of the world. The tech sector's heft in the S&P 500 index (33.3%) dwarfs that of the STOXX Europe 600 index (7%).

Potential Challenges

The sustenance of this impressive run remains uncertain. Trump's election victory has galvanized the concept of "animal spirits," leading investors to perceive a brightening outlook for the U.S. economy. As a result, the stock market rally could persist for some time, mirroring the behavior following the 2016 elections.

However, equity investors should remain vigilant against two looming risks:

1. Artificial Intelligence and Earnings Growth: If artificial intelligence does not catalyze the expected high earnings growth in leading tech stocks, as witnessed during the dot-com boom, a stock market correction similar to the early 2000s could ensue.
2. Trump's Tariff Policies: Trump's tariff threats pose a significant risk to the U.S. trade balance, as he views trade as a zero-sum game. Should the current account deficit widen further, investors should be prepared for a possible trade conflict, requiring a strategy to safeguard their portfolios.

Investors should closely monitor the U.S. external imbalance, which has doubled from 2% to 4% of GDP since the pandemic's onset. The U.S. trade balance could widen further in the years ahead due to a better economic growth rate and the dollar's strength, causing imports to become cheaper and exports to grow more expensive.

Trump's aides are reportedly considering universal tariffs over critical imports, paring down some of his campaign promises but still carrying significant implications for the U.S. economy and consumers. Despite this, Trump remains committed to increasing tariffs on China by up to 60% and imposing penalties on imports from Mexico and Canada.

My bottom line is that while investors may view Trump's threats as a negotiation tactic, they should not underestimate his capacity for enforcing them, particularly following the widening of the U.S. current account deficit. Investors must devise strategies to cushion their portfolios against a potential trade conflict's fallout.

References:

1. "Does globalization cause trade surpluses?" by D. A. Westerfield and Paul J. Williams, International Monetary Fund, December 2007
2. "The dollar's continued appreciation and the global economy" by Jeffrey Frankel, Brookings Institute, February 2021
3. "Trump's trade policy and U.S. currency dynamics" by Douglas J. Irwin, Dartmouth College, March 2021
4. "Trade tensions and their potential impact on the global economy" by World Bank, June 2019
5. "Impact of strong US dollar on export competitiveness" by International Trade Centre, April 2019

Enrichment Data:A robust U.S. dollar and Trump's tariff threats come with potential challenges for equity markets and trade balance.

Strong U.S. Dollar Risks:

1. Negative Impact on U.S. Exporters: A strong dollar can make U.S. exports more expensive abroad, potentially threatening their competitiveness and profitability.
2. Problems for Emerging Markets: When the dollar appreciates, developed countries like the U.S. may enjoy lower import costs, but emerging markets face higher external debt costs due to the stronger currency. In some cases, this may result in currency devaluations.
3. Inflation and Interest Rates: Inflation rises as imported goods become more expensive in a strong dollar economy, forcing the Federal Reserve to potentially keep interest rates higher than anticipated to curb inflation and slow down economic growth.
4. Global Supply Chain Disruptions: A stable dollar allows for cost-efficient global supply chains, but a strong dollar can disrupt their balance, particularly for industry sectors reliant on critical imports, such as semiconductors or rare earth metals.

Trump's Tariff Threats Risks:

1. Trade Tensions and Retaliation: If the U.S. imposes tariffs on imports from China, Europe, or other countries, it may ignite retaliatory measures from these nations, escalating trade tensions and negatively impacting global economic conditions.
2. Supply Chain Disruptions: Tariffs can lead to delays in the integration of global supply chains, raising manufacturing costs and potentially deterring investments.
3. Negative Impact on Specific Sectors: Industries, such as manufacturing and utilities, might benefit from tariffs, but other sectors would likely suffer from subsequent price adjustments, increased expenses, and losses due to reduced competition.
4. Legal and Economic Implications: Implementing tariffs may face legal challenges, and their negative consequences for global trade stability may lead to a decline in GDP across affected countries.

Combining both threats, investors should remain mindful of the potential risks for equity markets and the trade balance. These factors could lead to uncertainty, market volatility, and negative consequences for emerging markets and countries with substantial trade dependencies on the U.S. and China.

1. The trade war tension between the U.S. and other countries could escalate further if Trump's proposed tariffs on China, Mexico, and Canada are implemented.
2. The strong U.S. dollar, caused by investor optimism and a robust economy, could intensify the U.S. current account deficit, potentially leading to higher tariffs due to Trump's view of trade as a zero-sum game.
3. The Louvre Accord of 1987, similar to the Plaza Accord of 1985, was an attempt to weaken the dollar and reduce the U.S. trade deficit; however, its effectiveness in the long term remains debated.
4. Should the U.S. current account deficit widen due to a stronger dollar and wider trade deficit, it could trigger a response from Trump in the form of even more stringent tariffs, impacting the US stock market.

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