Mo Dollar Strength, Mo Problems

This past week was certainly a busy one on both the economic and earnings fronts. The Fed hiked interest rates again on Wednesday. A day later, new data showed the US economy shrank for the second quarter in a row, meeting one of the common criteria for a technical recession. And in a big deja vu moment for Europe, Russia once again sharply reduced the flow of piped gas to the region. Finally, results updates from several US tech giants all showed the strong dollar weighing on Big Tech’s earnings.

Macro

The Fed raised interest rates by 75 basis points for a second straight month on Wednesday, in a bid to cool down the hottest inflation pressures in 40 years. That takes the cumulative increase over the past two months to 150 basis points – the steepest set of rate hikes since the inflation-fighting era of Paul Volcker in the early 1980s.

Fed Chair Jerome Powell signaled that more rate hikes are coming but gave no further details, saying the magnitude of its next increase will depend on economic data. That makes sense: the Fed’s next interest rate decision isn’t until the 21st of September, meaning there are two inflation and employment reports in between. Powell also added that the Fed will slow the pace of rate hikes at some point, sparking a rally in US stocks and government bonds late on Wednesday.

A day after the Fed’s decision, new data showed the US economy shrank for the second quarter in a row, meeting one of the common criteria for a technical recession. US GDP shrank by 0.9% on a year-on-year basis in the second quarter. That follows a 1.6% decline in the first quarter and was significantly worse than the 0.3% gain economists were forecasting. On a quarter-on-quarter basis, GDP shrank by 0.2%. However, despite the worse-than-expected figures, stocks rallied and bond yields fell. That might seem counterintuitive, but one explanation could be that markets have entered a phase where “bad news is good news”. Put differently, investors may be betting that weak economic data will push the Fed to pause its aggressive rate-hiking campaign, which would be supportive of stock and bond prices.

Stocks

As the second-quarter earnings season gets well underway, investors are nervously fretting over the strong dollar’s impact on US corporate profits. The currency shock comes at a time when earnings are already being closely watched for signs of a weakening economy, as red-hot inflation and higher interest rates weigh on businesses and consumers.

The dollar index (or “DXY”) – a measure of the value of the US dollar relative to a basket of foreign currencies – has increased by around 15% over the past 12 months, recently hitting a 20-year high. The surge is mainly down to the Fed’s most aggressive rate hiking campaign in decades: higher interest rates, after all, make the dollar more appealing to international savers and investors. And that appeal is set to increase even further after the Fed delivered another jumbo rate hike of 0.75 percentage points on Wednesday.

US firms with large businesses abroad are starting to feel the pain, as the strong dollar lowers the value of their international sales. In fact, from the graph below, you can see that the S&P 500 firms, as a whole, made 29% of their $14 trillion of revenues in 2021 abroad, according to Goldman Sachs. That share is even higher for investors’ favorite sector: Big Tech. Goldman estimates that 59% of sales for tech companies in the S&P were generated outside of the US.

A strong dollar comes on top of an economic slowdown in Europe and Covid-related lockdowns in China, all of which are hurting sales at US firms with large foreign operations. No wonder then investors are shying away from shares of companies with large businesses abroad, favoring shares of companies with primarily US operations instead. So much so is evident from Goldman’s index of US companies with large international exposures, which has underperformed its domestic counterpart by more than 10% this year.

Microsoft, which reported its latest results on Tuesday, can certainly relate: the strong dollar knocked $600 million off its revenue last quarter. That – combined with weaker demand for cloud services, PC software, and online advertising – caused Microsoft’s revenue and profit to fall short of expectations, breaking a winning streak of 14 straight quarters of beating analyst estimates. The firm’s sales grew 12% last quarter compared to the same time last year – its slowest revenue growth since 2020. Still, Microsoft gave an upbeat forecast for its fiscal year that just began, saying it expects revenue and operating income to increase at a double-digit pace. Investors liked what they heard and sent Microsoft’s shares more than 5% higher after the update.

Google-parent Alphabet also reported worse-than-expected earnings on Tuesday. Similar to Microsoft, Alphabet’s sales grew just 13% last quarter compared to the same time last year – its slowest pace in two years. And also similar to Microsoft, the strong dollar dented Alphabet’s results, knocking 3.7 percentage points off revenue growth. The one bright spot was advertising sales at Google, which managed to post revenue that beat analysts’ estimates despite slowing growth. That came as a huge relief: just last week, Snap announced disastrous quarterly results which it attributed to a major slowdown in the digital advertising market. Relieved investors sent Alphabet’s shares more than 4% higher after the update.

Google’s closely watched cloud division, which has yet to turn a profit, grew revenue by 36% and lost $858 million last quarter, up from a loss of $591 million during the same time last year. Although Google is a distant third in the cloud market (behind Amazon and Microsoft), the effort is nonetheless viewed as one of the company’s best bets for growth as its core search business matures.

Moving on to Meta Platforms, the social media giant that owns Facebook and Instagram didn’t manage to escape the slowdown in the digital advertising market. Making matters worse, Apple’s privacy updates last year have made ads on Facebook and Instagram less effective. All in all, Meta’s second-quarter revenue slipped to a lower-than-expected $28.8 billion. That represented a 1% sales decline from a year ago – the firm’s first-ever revenue drop on a year-on-year basis. Meta also gave a disappointing outlook for the current quarter, forecasting a second consecutive decline in year-over-year sales. The disappointing results sent Meta’s shares 4% lower, bringing its year-to-date decline to over 50%.

Commodities

In a deja vu moment for Europe, Russia once again sharply reduced the flow of piped gas to the region. Gazprom cut shipments on the Nord Stream pipeline – Europe's main gas import infrastructure – to about 20% of its capacity on Wednesday. The pipeline was previously operating at 40% capacity, so Wednesday’s move effectively halved flows to the bloc and sent European natural gas prices surging to a five-month high.

According to Gazprom, maintenance issues with a turbine that helps pump gas into the pipeline are behind the curbs. But some European politicians are skeptical, accusing Russia of weaponizing energy supplies. Makes sense then that the EU green-lit a proposal this week to voluntarily cut its natural gas consumption by 15% over the next eight months, as the bloc braces for the prospect of a full cut-off from Russian gas supplies.

Next week

Earnings season continues with some more tech names reporting including Pinterest, Advanced Micro Devices, and Alibaba. Investors will also be closely watching earnings releases from Airbnb, Uber, PayPal, and Starbucks, to assess consumer spending during the key summer holiday season. On the economic front, some of the key releases include Chinese PMIs on Tuesday and the Bank of England’s interest rate decision on Thursday, with investors expecting the central bank to hike rates by 50 basis points.