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Why The Strong U.S. Dollar Is Still A Headwind For International Consumer Staples Stocks

[Editor’s Note: This is the fourth and final installment in our series on consumer staples stocks. See also: – Part I : The Monsters Under the Bed are Real for Consumer Staples Stocks – Part II : Don’t Get Caught Holding This “Safe” Stock When the Fed Hikes Rates – Part III : What Happens When “Engineered Growth” is No Longer Viable Please let us know what you think of the series. Use the comment section below..] As we approach the end of the second quarter and enter earnings season, currency headwinds are likely to significantly cut into earnings for international consumer staples stocks. Investors in consumer staples stocks are already facing some serious challenges. We’ve discussed the high valuations as a result of income investors reaching for yield . These valuations are still well above average levels even after many of these stocks have sustained declines. As this reach for yield unwinds, valuations should contract, sending stock prices even lower. A second challenge comes from the end of an ” engineered growth ” phase. Companies have had an incentive to borrow money cheaply and buy shares of their own stock. This has reduced the share count, thereby artificially inflating earnings per share. But with valuations now inflated and with higher rates making it more expensive to borrow, the buyback fad will likely end. Investors who became accustomed to this engineered growth may be disappointed with lower growth rates in subsequent quarters. Today, we’re going to discuss the very real challenge of the strong U.S. dollar, as it relates to consumer staples companies who do business around the world. How the U.S. Dollar Affects Business Basic economics tells us that a weak currency helps to promote a country’s exports. This is because other countries’ currencies go farther towards purchasing goods and services, making the country with a weak currency more competitive. The opposite is true as well. When a country’s currency is strong, it becomes more challenging for that country to export products or services. The strong U.S. dollar has become a significant headwind for domestic companies who generate a significant amount of revenue overseas. Today, a U.S. company selling a product in international markets must choose between two options: Sell the product at a competitive price. In this scenario, the company may collect a steady amount of profit in euros (using just one currency as an example). But since each euro represents fewer U.S. dollars, the company’s profit margin will decline in dollar terms. Sell the product at a standard U.S. dollar price. In this scenario, the company can protect its profit margins by selling at a high enough price to keep profits per unit at a steady level. But since this price will be higher in euro terms, the product will be less competitive when compared to competing products. There is perhaps no better example of this problem for consumer staples stocks than Philip Morris International (NYSE: PM ). The company has the third largest position in the S&P Consumer Staples SPDR (NYSEARCA: XLP ) Philip Morris International is the international sister company of Altria Group (NYSE: MO ) following the company’s split. Philip Morris sells cigarettes and tobacco products outside the United States while Altria operates in the U.S. In the first quarter, PM reported 7.8% growth in sales when calculated on a “constant currency” basis. But when international sales were translated into dollar figures, revenue actually fell more than 4%. Adjusted earnings were also reported 2.5% lower than last year’s results, all a result of the strong U.S. dollar. We should note that when PM reported its results, shares traded higher. Investors chose to focus on the strength of PM’s international sales, hoping that the strong U.S. dollar would be a temporary factor, while expecting further international growth from PM. In addition to Philip Morris, many other international consumer staples companies have reported weakness due to the strong U.S. dollar. Here are just a few… Johnson & Johnson (NYSE: JNJ ) cut its guidance in April due to the strong U.S. dollar. The Coca-Cola Company (NYSE: KO ) reported a 6% cut to revenue as a result of the U.S. dollar Procter & Gamble (NYSE: PG ) reported a 5% negative impact to its sales due to the U.S. dollar Unfortunately, for international consumer staples stocks, it doesn’t look like this trend will reverse any time soon. It’s Still a Bullish Environment for the U.S. Dollar After advancing sharply in the second half of 2014 (and the first few months of 2015), the U.S. dollar has been trading in a more stable range the last several months. Many believe that the sharp rise in the dollar is complete and that while the trend may not reverse, the dollar is not likely to trade materially higher. Currencies have a reputation for long-term trends extending several years. Below is a long-term chart of the U.S. dollar index that we marked up to show the amount of time (and level of change) between peaks and troughs. Since the 1970s, the U.S. dollar has experienced five major trends lasting anywhere from 6 years to nearly 10 years. The average advance has been near 70% and the average decline near 45%. (Admittedly, this is a small sample size, but it is at the very least a rough gauge of the magnitude of typical U.S. dollar trends). While the current rally in the U.S. dollar has lasted seven years from its trough in 2008, the dollar has only advanced 38%. If the dollar were to continue to rally, it wouldn’t be outside the “normal” band for currency movements. Plus, one could argue that the true bottom didn’t occur until 2011 when the dollar bottomed against the yen and the Australian dollar. Fundamentally, there are compelling reasons why the dollar could continue to rally. The three biggest are: Continued uncertainty surrounding sovereign debt for Eurozone countries could cause institutions and individuals to gravitate away from euros and towards U.S. dollars. A weakening Chinese economy and lower oil prices are challenges for natural resource countries like Canada and Australia. This trend is just beginning and should continue to weigh on the Canadian and Australian dollars. Rising interest rates in the U.S. should make dollar-denominated deposits more attractive. As treasury yields rise, more international investors will convert savings to dollars and buy government bonds. While short-term movements in currencies are difficult to game, we believe that the bullish trend for the U.S. dollar is still intact, and that it will pressure earnings for international consumer staples companies. The U.S. Dollar Remains a Challenge for Q2 Results Despite a few weeks of sideways trading, the U.S. dollar remains significantly elevated from where it was last year. Today, the U.S. dollar is 21% stronger versus the euro than at this time last year. The U.S. dollar is 18% stronger versus the Australian dollar than at this time last year. The U.S. dollar is 13% stronger versus the Canadian dollar than at this time last year. When U.S. consumer staples companies with international sales report second quarter metrics next month, they will be up against a significant headwind. Last year during the second quarter, these companies did not face a strong dollar. This year, earnings will not compare favorably to last year’s numbers. At this point, it doesn’t matter what the U.S. dollar is going to do when it comes to second quarter results. Instead, it matters where the dollar is versus at this time last year. The key will be how investors respond to the reports. If they see the strong U.S. dollar as a temporary issue, investors may once again look the other way and the stocks may hold up. But if investors are worried about continued strength in the U.S. dollar, we believe that international consumer staples companies will trade lower in the days leading up to and following their second quarter announcements. With the Fed on tap to release its June statement tomorrow (this article is being penned after the close on Tuesday, June 16th), we could be in danger of seeing another spike in the U.S. dollar this week. Any hawkish rhetoric from the Fed, or any indication that the first rate hike will come in September could send the U.S. dollar higher. In an environment where the dollar is once again on the move, we don’t expect investors to give international consumer staples stocks the benefit of the doubt when it comes to the second quarter earnings announcements. Three Major Challenges So when it comes to consumer staples stocks, we’re decidedly cautious. We prefer to avoid these risky shares while waiting for three major challenges to pass. These challenges are: An unwinding of the “reach for yield” A curtailment of “engineered growth” A strong U.S. dollar headwind.

China A-Shares: Worth The Wait?

MSCI decided last week not to include China A-shares on the MSCI Emerging Markets Index. The index compiler has decided to defer this decision until it sorts out outstanding issues with the country’s securities regulator. In the same week, data from EPFR Global showed that $9.3 billion was pulled out of emerging market funds and most was from China. This was the biggest weekly outflow in 15 years. Now, the Institute of International Finance (IIF) has warned that emerging markets may face more exodus as the US central bank approaches a “lift-off”. Before we focus on relevant mutual funds, let’s look into some other details. China A-shares The decision to not include China A-shares at least now comes as a temporary setback to China’s efforts to raise the standing of mainland capital markets and internationalize the yuan. China A-shares are listed in Shanghai and Shenzhen. These are denominated in yuan. However, this should be good news for other countries whose stocks are listed on the index. Emerging market investment instruments would thus gain, as this non inclusion will help keep the money flow to them. Outstanding Issues According to MSCI’s website, it will only include mainland shares after it resolves certain outstanding issues. The company said it will form a working group with China Securities Regulatory Commission, the country’s securities regulator for this purpose. Among the issues to be resolved were capital mobility, beneficial ownership details and restrictions on investment. The measured approach adopted by MSCI on A-shares has been praised by several market watchers and analysts. Restrictions on Investment Foreign investors still have to conform to restrictions on investments per the conditions laid down by authorities regarding the Shanghai-Hong Kong exchange link. This link which commenced in November provides investors with a brokerage account in Hong Kong with access to stocks listed on the mainland. However, foreign investors can purchase a maximum of net 13 billion yuan ($2.1 billion) of such shares per day. They are also subject to an aggregate quota of 300 billion yuan. MSCI has said that it will collaborate with Chinese authorities to ensure that such quotas correspond to the amount of assets under management of investors. Close coordination with China’s authorities will hasten this process, the index provider said. However, the announcement of the inclusion of A-shares and the implementation will be separated by a 12-month period. More Exodus On the other hand, IIF believes there may be more outflows from emerging markets. Jean-Charles Sambor, Asia Pacific director at the IIF, said: “We think the weakest emerging markets are likely to continue to suffer from pretty large outflows both on the debt side and equity side.” However, the outflows may be prominent for weaker economies having weak macro fundamentals. These economies mostly pertain to the Middle East and Latin America. Also, of the $9.3 billion outflows from emerging market funds, China equity funds accounted for $7.1 billion of the outflows. This probably hints that not all emerging market economies may be in a spot of bother. Short Term Setback Most analysts believe that this setback for A-shares is only short term in nature. Even though, the majority of market participants would have liked the inclusion to come much sooner, MSCI has sent out a clear signal. Fund managers would have to factor in the possibility of such a change taking place before 2016. In fact, China has already dealt with major concerns on market accessibility raised after last year’s MSCI review. Firstly, an announcement was made in November last year that shares bought via the exchange link will be temporarily exempted from capital gains taxes. Authorities have also reduced restrictions on having more than one broker. Additionally, they have also initiated a trial run of same day trading of select stocks. Funds in Focus If the setback is a temporary phenomenon, certain emerging market and pacific funds would continue to be great investments. The recent dismal performance should not be a cause for concern. Top-ranked funds with great fundamentals should be good additions to portfolios. In any case, the non-inclusion of China A-shares means money would stay with the other emerging market countries’ investment instruments. The following funds carry either a Zacks Mutual Fund Rank #1 (Strong Buy) or Zacks Mutual Fund Rank #2 (Buy) as we expect the funds to outperform its peers in the future. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but the likely future success of the fund. They also have encouraging year-to-date and 3 and 5-year annualized returns. They carry no sales load and the minimum initial investment for these funds is within $5000. Matthews Korea Fund (MUTF: MAKOX ) seeks capital growth over the long-term. MAKOX invests a large chunk of its assets in common and preferred stocks of South Korea companies. The fund focuses on mid to large cap firms, but is not restricted to them. MAKOX currently carries a Zacks Mutual Fund Rank #1. MAKOX boasts year-to-date return of 12% while the 3 and 5 year annualized gains stand at 14.7% and 12.4%. Wells Fargo Advantage Asia Pacific Fund (MUTF: SASPX ) seeks capital growth over the long run. SASPX allocates a lion’s share of its assets in equities of companies located in Asia Pacific Basin. SASPX emphasizes on factors including earnings growth, financial condition and management efficiency for selecting companies. SASPX may also invest in participation notes. SASPX carries a Zacks Mutual Fund Rank #2. SASPX boasts year-to-date return of 9.3% while the 3 and 5 year annualized gains stand at 15% and 10.4%. Fidelity® Emerging Asia Fund (MUTF: FSEAX ) invests heavily in companies from emerging economies in Asia. FSEAX may also invest in other securities that are related to emerging markets of Asian countries. FSEAX focuses on acquiring common stocks of companies depending on factors such as economic conditions and financial strength. FSEAX carries a Zacks Mutual Fund Rank #2. FSEAX boasts year-to-date return of 7.2% while the 3 and 5 year annualized gains stand at 12% and 8.9%. Original article on Zacks.com

Allocating Assets When The Fed Talks Out Of Both Sides Of Its Mouth

One year ago, each of the 17 members of the Federal Reserve provided an expectation of where the fed funds rate would be at the end of 2015. The average came in at 1.1%. Here in mid-June, the average expectation for committee members for the end of the year now registers 0.45%. If the party is set to rage on, then, shouldn’t investors aggressively allocate dollars in U.S. equities? Not from my vantage point. One year ago, each of the 17 members of the Federal Reserve provided an expectation of where the fed funds rate would be at the end of 2015. The average came in at 1.1%. That might have required four to five rate hikes this year alone. By March, the expected year-end rate dropped to 0.65%. Perhaps two or three rate increases, then? Nope. Here in mid-June, the average expectation for committee members for the end of the year now registers 0.45%. The financial markets have even less conviction about a 2015 increase to the cost of borrowing. Investors via fed funds futures are only pricing in a 22% chance that the Federal Reserve raises the benchmark rate in September and a 62% probability of a rate liftoff at the central bank’s December meeting. Personally, I imagine one face-saving hike this year – a one-n-done to say that they did it. Nevertheless, nobody will be removing much of the alcoholic punch from the the party’s punch bowl anytime soon. Diminished expectations have not been confined to 2015 alone. Fed forecasts for year-end 2016 have dropped from roughly 1.9% to 1.6%. For 2017, they’ve moved down to 2.9% from 3.1%. And that’s not all that the Fed has downgraded. As recently as three months earlier, the institution anticipated 2015 economic growth at 2.3%-2.7%. Yesterday, committee members revealed an assessment of a lethargic 1.8% to 2.0%. Wait a second. Haven’t chairwoman Yellen and her colleagues been prattling on about economic acceleration since last year? Haven’t they been stressing transitory factors to explain every bit of weakness, while simultaneously pointing to improvements wherever they can be emphasized? With one side of its collective mouth, committee members are talking up the economy’s advances. With the other side, it currently believes that the economy will grow even slower than its post-recession growth rate of approximately 2.1%. Keep in mind, our 2.1% post-recession performance is historically weak under normal circumstances. Since 6/2009, though, America received $7.5 trillion in stimulus by the U.S. government; we received $3.75 trillion in electronic dollar equivalents by the Federal Reserve. In other words, unprecedented fireworks only enabled the economy to grow at a lethargic pace. Meanwhile, based on what the Fed members report outside of the media spotlight, they anticipate additional cooling off here in 2015 (circa 1.8%-2.0%). Is it any surprise that stocks would rocket on the probability of fewer anticipated rate hikes alongside a less vibrant economy ? Heck, the Fed successfully talked down the U.S. dollar, kept bond yields from extending their recent tantrum and sent the SPDR Gold Trust ETF (NYSEARCA: GLD ) back above 50-day moving average. If the party is set to rage on, then, shouldn’t investors aggressively allocate dollars in U.S. equities? Not from my vantage point. Successful investors tend to sell complacency, rather than purchase more of it. And “risk-on” investors have become incredibly complacent with respect to sky high valuations as well as Fed accommodation. Understand the real reason that the Fed is even talking about raising short-term rates at all. The monetary policy authorities need to bolster the Fed’s arsenal before the next recession, external shock and/or “black swan” event. They are no longer capable of moving from a 5% fed funds rate range down to 1% or 0%. Instead, we’re now talking about maybe – possibly, someday – getting up to 3% before going back to 0% rate policy and a 4th iteration of quantitative easing (“QE4”). In truth, I doubt that the Fed will ever be able to move beyond 1% before reversing course. Japan has spent the last 15 years stuck at 0.5% or less. That has everything to do with our reliance on zero percent rates and asset purchases with currency credits (“QE”) for six years. Japan made the same error in judgment. Admittedly, the Fed has been marvelously successful at persuading businesses to buy back their stock shares; they’ve convinced pensions, money managers, mutual funds and real estate investors to stay engaged, enhancing the “wealth effect” for the wealthiest among us. (Yes, that includes me.) On the other hand, I have seen the same excesses throughout the decades. I witnessed firsthand what happened to Taiwanese equities in 1986 when Taiwan R.O.C. opened its doors to outside investors. The irrationally exuberant run-up met its panicky demise the following year. I warned investors to have an exit approach to the insanity of dot-com euphoria in the late 1990s; I offered the same warnings leading up to the 2007-2009 financial collapse. In essence, you do not have to be sitting 100% in cash. We still remain invested in core positions such as the Vanguard Mid-Cap Value ETF (NYSEARCA: VOE ), the iShares S&P 100 ETF (NYSEARCA: OEF ) and the Vanguard High Dividend Yield ETF (NYSEARCA: VYM ). Yet we have also raised 10%-25% cash in our portfolios (depending on client risk tolerance) as stop-limit loss orders have hit on both bond and stock positions. We let go of energy investments that did not pan out. We stopped out of longer-term bonds earlier this year. And Germany via the iShares Currency Hedged MSCI Germany ETF (NYSEARCA: HEWG ) is no longer in the mix of any client. The result? More cash for future buying opportunities. And that buying opportunity is likely to be far more consequential than a 3% pullback. With only a few exceptions, we believe it is far more sensible to wait for the real deal – a 10%-plus correction and/or a 20%-plus bear. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.