CPI Data released on Tuesday showed 2021 to be the highest inflationary period since 1982, closing out the year with a staggering 7.0% year-over-year increase in prices. With inflation continuing to rise, all eyes are on the Federal Reserve and its view of future rate hikes, adding an additional element of intrigue to Jerome Powell’s confirmation hearing. Throughout Tuesday’s session, Powell went to great lengths to avoid providing the market any new information before the Fed’s next meeting at the end of January. However, the Fed Chairman did acknowledge that the tools at his disposal are fairly limited when it comes to affecting supply-side inflation. Solving the inflation issue at this moment would mean either increasing the supply of goods (i.e. resolving the bottleneck issue) or reducing consumer demand (i.e. making Americans poorer so they must tighten their belt and reduce spending). While Mr. Powell could always raise rates to drive the U.S. Economy into a recession, one would be hard pressed to find any American that finds this a palatable way forward. Nevertheless, unless Omicron burns out quickly across the globe (including China, which just transitioned from a ‘Covid Zero’ Policy to a ‘Dynamic Clearing’ model), rate increases are inevitable this year, which is not so great news for markets.
Many investors believe rate increases drive down equities as people shift funds from equities to bonds as higher yields finally rationalize the risk-reward matrix, or that the increased cost of borrowing decreases new projects, creating a weaker job market driving down domestic demand. Yet, in an increasingly globalized economy, there is one item that is oft overlooked – the value of the dollar abroad. Historically, as rates increase, so does the value of a dollar to the international community (the reason being that foreign investors will convert more of their capital into USD to reap the benefits of higher interest rates), which could spell trouble for earnings. As of last year, 40% of the S&P 500’s earnings were generated outside of the United States. In a situation where rates increase and the dollar appreciates to foreign currencies, it is very possible that earnings fall. Not because of a slow down in goods or services provided abroad, but rather because the currency that the goods and services are billed in has been devalued relative to the dollar. A stronger dollar also means lower global liquidity in financial markets, as foreign denominated currencies are less able to buy dollar denominated assets.
While a strong dollar may make your international vacations less expensive (that is when we are allowed to travel again), it may also have a deleterious impact on your investments.