by Jeffrey Kleintop, CFA® Managing Director, Chief Global Investment Strategist, Michelle Gibley, & Heather O'Leary, Charles Schwab & Co., Inc.
Dollar strength resulting from central banks' independent policies on rate cuts is unlikely to be tampered by China's deflation or geopolitics.
Diverging paths
Market-based percentage likelihood of a rate cut in June
Source: Charles Schwab, Bloomberg data as of 4/18/2024.
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Market-based number of rate cuts priced in for 2024
Source: Charles Schwab, Macrobond, Intercontinental Exchange (ICE), as of 4/18/2024.
Futures, and Futures options trading involves substantial risk and is not suitable for all investors. Please read the Risk Disclosure Statement for Futures and Options prior to trading futures products. Past performance is no guarantee of future results.
- A stronger dollar could eventually hurt earnings for U.S. companies through making exports less competitive and weighing on the earnings growth of U.S. companies' overseas-sourced profits. Earnings growth of non-U.S. companies on their U.S. sales could benefit.
- A stronger dollar also boosts commodity exporters and acts as a drag on commodity importers because crude and other industrial goods are typically quoted in dollars. The Energy and Materials sectors tend to do well in this environment (see our latest Sector Views).
- Stock market valuations in countries where rates are likely to be cut more aggressively may rise, offsetting the drag on performance from a falling currency for U.S.-based investors. We have been seeing this effect with the price-to-earnings ratio rising for much of this year for the MSCI EAFE Index, contributing to its total return and offsetting the drag from currency impacts.
Rising valuation offsetting falling currency on total return
Source: Charles Schwab, Bloomberg data as of 4/18/2024.
Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Is China the answer to U.S. inflation?
Data represents change in CPI from a year ago for each country.
Source: Charles Schwab, Bloomberg data, Statistics Canada, Eurostat, Ministry of Internal Affairs & Communications Swiss Federal Statistical Office, UK Office for National Statistics, US Bureau of Labor Statistics as of 4/18/2024.
Inflation in China remains near zero
Source: Charles Schwab, Bloomberg data as of 4/18/2024.
Green areas are periods of positive inflation, and red areas are periods of negative inflation.
- First, among developed economies like the U.S., imports from China make up less than 2% of overall household consumption—with most of the current pace of inflation coming from services which are not imported from China. Services contributed 3.2% of the 3.5% headline CPI for the U.S. in March, and 1.8% of 2.4% headline CPI in the eurozone. Using the same periods, goods prices subtracted from overall U.S. CPI and contributed to only 0.3% to eurozone CPI. The modest impact of lower goods prices is unlikely to offset still high services prices.
- Second, import prices are only a small portion of the final price of a good, which is often more influenced by wholesale and retail services performed in the destination country. The San Francisco Fed estimates nearly half of spending on imports stays in the U.S. paying for the local components of these goods. One example indicated $25 of the $100 price of athletic shoes manufactured in China by a U.S. company went to the Asian factory, while the rest of the price represented profits of the U.S. company, transportation costs, wages for workers in U.S. warehouses and retail stores, rental cost for retail space, insurance, etc.
- And third, China's infrastructure spending and manufacturing stimulus could add to global inflation pressures if greater demand boosts commodity prices, like those for base metals which have tend to be up sharply this year.
Moreover, excess capacity in China is nothing new that would prompt a sudden trade shock. Low levels of capacity utilization have been a feature in China for over a decade, rotating among different industries, with current excess in the automobile industry, according to comments by U.S. Treasury Secretary Yellen and EU Commission chief Ursula von der Leyen. So, it is unlikely that China is the solution to the U.S. inflation problem. Counterintuitively, very low export prices may incite higher tariffs. If the export price is low enough that it prompts lawmakers to institute new and bigger tariffs in efforts to protect domestic industry, it can increase prices for consumers. It would follow then that additional U.S. tariffs on Chinese produced goods, such as the recently proposed rise to steel tariffs, may further boost U.S. inflation and serve as a counterpoint to any arguments for deflationary effects from inexpensive imports.
Is geopolitical risk driving the dollar?
Geopolitical events involving Russia or Middle East
Source: Charles Schwab as of 4/15/2024.
Market reactions leading up to and following geopolitical events
Source: Charles Schwab, Bloomberg data as of 4/18/2024.
Global stock prices are illustrated using performance of the MSCI World index. Gold prices are illustrated using Gold/USD futures. Oil prices are illustrated with Brent Crude futures contracts. The value of the U.S. Dollar is illustrated using the U.S. Dollar Index (DXY). Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Of the 28 total periods, global stocks were up in the month prior to the event during 15 of them—a little more than a coin flip and slightly less than the two-thirds of the time that a month posted an average gain over the full 55-year period. Perhaps this softer performance in the month prior to an event reflects some concern over heightened geopolitical tensions. Of those same 15 periods, stocks were down five times one month after the event, three of which were during recessions, making geopolitics unlikely to be a key reason that stocks were down. As for the remaining two periods? The ascendancy of Putin as president of Russia in December 1999 preceded the start of the 2000 Dot Com market crash and the capture of Osama Bin Laden in May 2011 aligned with the European Debt Crisis. In our opinion, these two geopolitical events happened coincidentally with major economic events, making them unlikely to have been a key driver of stocks' declines during those periods.
A 55-year-long look at history shows very few times—if any—that a geopolitical event was a major factor in changing market trends. Of course, there is always the potential for a first time.
Michelle Gibley, CFA®, Director of International Research, and Heather O'Leary, Senior Global Investment Research Analyst, contributed to this report.