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How U.S. Economy Centric Is Your U.S. Equity Exposure?

Jeremy Schwartz, CFA, Executive Vice President, Global Head of Research

Given today’s increased focus on the global economy, investors are likely aware of how foreign currency movements can impact their international investments. But the U.S. dollar can affect domestic equities as well. Many U.S. companies generate a large portion of their revenue outside the United States. A strong dollar can hurt these companies’ competitiveness as their goods and services become more expensive to their international clients. As a result of the recent dollar strength, many of these U.S. exporters have reported large currency headwinds as part of their earnings statements this year, which has hurt their performance compared to European and Japanese exporters, who have benefited from the yen and euro, respectively, weakening against the U.S. dollar. Jon R. Moeller, Chief Financial Officer of Procter & Gamble, summarized the challenges facing many companies during P&G’s most recent earnings call:
“Core earnings per share for the year were $4.02, down 2% versus the prior year. This includes a 13-point headwind from foreign exchange (FX), over $1.5 billion after tax.
“Foreign exchange will continue to be a significant sales and earnings headwind, particularly in the first two quarters. To offset the foreign exchange impacts and restore structural economics, we’ve taken significant price increases in some markets. We need to manage through the market contraction and volatility that naturally follow.
“We have disproportionately large positions in the markets most affected by FX. We’re market leaders in Russia, the Ukraine, in Japan and in Venezuela. In contrast, many of our internationally domiciled competitors are benefiting from their weaker currencies, providing fuel for reinvestment.”1
  On the other hand, there are domestically oriented companies that may perform better when the dollar is strong, because their earnings are not driven by foreign sales. In the chart below we quantify the weighted average revenue coming from within the United States to get a sense of how sensitive an index may be to fluctuations in the dollar.   Index Weighted Average Revenue from Within the U.S. Index Weighted Average Revenue from Within U.S.WisdomTree Strong Dollar U.S. Equity Index generated the highest percentage of revenue from within the U.S. This Index includes only firms that derive more than 80% of their revenues from within the United States. These companies tend to be less impacted by a strong-dollar environment—they aren’t focused on selling their goods and services abroad, and their import costs decrease with a rising purchasing power of the dollar. The Index also tilts weight more heavily toward stocks whose returns have a higher correlation to the returns of the U.S. dollar.   • Small- and Mid-Cap Indexes – typically generate a higher percentage of their revenues from their domestic economies than do large-cap indexes. Another way to potentially steer around the negative earnings impact from a strong dollar would be to focus on small- and mid-cap companies, which tend to be less reliant on exports to drive revenue.   • WisdomTree Weak Dollar U.S. Equity Index generated the lowest percentage of revenue from within the U.S. This Index includes only firms that derive at least 40% of their revenues from exports. These firms tend to be more impacted by a strong-dollar environment, as they are focused on selling their goods and services abroad. Similarly, during a weak-dollar period, we’d expect these firms to become more competitive in selling their goods abroad. The Index also tilts weight to stocks whose returns that are more negatively correlated (or have a lower correlation) to the returns of the U.S. dollar.   What Are Your Thoughts on the Dollar? Among the most important macroeconomic forces impacting the market have been currency changes motivated by diverging monetary policies. If you believe the U.S. dollar will continue to strengthen over the coming years, as is WisdomTree’s baseline view, this can provide continued headwind to U.S. exporters. In response, we think it makes sense to favor the WisdomTree Strong Dollar U.S. Equity Index or indexes focused on mid- and small-cap companies. Conversely, if you believe the U.S. dollar trend is set to reverse, such an environment would favor U.S. exporters and the WisdomTree Weak Dollar U.S. Equity Index.         1Procter & Gamble Q4 2015 Earnings Call Transcript, 7/30/15.

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