By Russ Koesterich, BlackRock’s Global Chief Investment Strategist
A tale of two trends
Stocks in the US tumbled last week, with the exception of a one-day rebound on Thursday. The Dow Jones Industrial Average fell 0.60% to 17,749, the S&P 500 Index dropped 0.87% to 2,053, and the Nasdaq Composite Index fell 1.14% to close at 4,871. Meanwhile, the yield on the 10-year Treasury lost from 2.25% to 2.12% as its price correspondingly rose.
Equity markets continue to be driven by two interconnected trends: diverging monetary policy and a stronger dollar. The recent underperformance in US equities is largely a function of these two dynamics, along with more expensive valuations. Some investors are reacting by focusing on domestic consumer stocks, and while this is a reasonable strategy, sluggish retail sales call into question whether or not the consumer will rebound as strongly as investors hope.
Dollar surge: Too much of a good thing?
With the European Central Bank’s (ECB) quantitative easing program now in full swing and investors anticipating a greater likelihood of a June rate hike by the US Federal Reserve (Fed), the dollar’s ascent is accelerating. (The ECB’s bond buying lowers yields in Europe, increasing demand for US securities and thereby raising the value of the dollar versus the euro.)
The Dollar Index is now at a 12-year high, up roughly 25% from last year’s lows. In contrast, US stocks are essentially flat year-to-date. This is no coincidence.
While a cheaper currency is proving a boon for European and Japanese companies, the stronger dollar is creating a problem for US exporters. The latest victim is Intel, which cut its current quarter revenue estimate by roughly $1 billion last week. A stronger dollar was cited as a contributing factor.
Adding to the challenge, the headwind on US earnings is occurring at a time when US valuations are expensive relative to other developed markets. The S&P 500 Index is trading at nearly three times book value, versus 1.67 for Europe and 1.75 for Japan.
Without the tailwind of further multiple expansion––that is, investors paying more for each dollar of earnings, something that is harder to achieve with the Fed set to start raising interest rates––the market is left relying on earnings growth, where the rapid rise of the dollar is proving an impediment.