How Currencies Movements Affect Earnings

Exploring the Role of Currencies in Earnings Performance

The eurozone may have reported just 3% growth in gross domestic product (“GDP”) in 2014, but fourth quarter earnings soared more than 10%. In the U.S., S&P 500 earnings slowed over the same time frame to about 6%, despite robust economic growth. Many analysts and investors attribute these counterintuitive dynamics to currency movement. During 2014, the euro lost a significant amount of its value relative to the U.S. dollar, which helped boost domestic spending and the global competitiveness of exports.

In this article, we’ll take a closer look at how currency movements impact corporate earnings and how international investors should react.

Consumers Love a Good Bargain

The Economist’s Big Mac Index provides an excellent tool for understanding how currency movements impact domestic spending. Since McDonald’s restaurants are ubiquitous around the world, the price of the Big Mac provides a great proxy for the rising and falling prices of consumer goods across many different countries around the world. The key point to realize is that the prices of these goods tend to move alongside changes in currency valuations.

In the eurozone, consumers witnessed the price of a Big Mac fall to around $4.26 by February 2015, while prices steadily rose in the United States to around $4.79 over the same time frame. The falling price of consumer goods leads to greater spending in much the same way that lower gasoline prices lead to more driving.

In the U.S., the rising costs of consumer goods may lead to the opposite move to cut back on spending.

Greater consumer spending translates to higher revenue and profit for domestic companies operating within these countries, which explains part of the reason that eurozone companies were able to generate 10% earnings growth.

Built-in Advantages for Exporters

Suppose that a European and U.S. lemonade stand selling glasses of lemonade at an international airport next to each other. The lemonade stands charge the exact same amount for a lemonade based on the exchange rate for the week. If the price of the euro falls versus the dollar mid-week, the European lemonade becomes much cheaper for U.S. visitors that earn dollars and can exchange them for euros.

The euros fall against the dollar in early 2015 involves these same dynamics when it comes to exports competing in global markets. Since European are more competitively priced, they realize higher sales volumes around the world for consumers buying on price. According to Europe’s largest drugmaker, every 1% drop in the euro versus the dollar adds 0.5% to its earnings per share, which quickly adds up to higher corporate profits.

Lower currency valuations translate to higher revenue and profit, especially for companies that export goods and services abroad, which explains another key reason that the eurozone companies were able to generate 10% earnings growth.

Earnings Growth that Isn’t Real

International investors should realize that the earnings growth generated from changes in currency valuation isn’t real in many senses.

Without an improvement in the underlying economy, these growth rates are likely to be only temporary fixes to a long-term problem that will eventually catch up with the companies. Investors can convert these currency valuations to a standard like gold to get a true picture of what the earnings mean.

Falling currency valuations can also lead to a host of other problems for regions and countries implementing these policies. Obviously, stagflation and inflation are the two primary concerns when the central bank printing presses are running. These dynamics can cause long-term declines in economic growth or even sharp economic crises if they aren’t properly managed, which can be detrimental to the long-term health of corporations within their borders.

In the end, investors should look beyond the headline earnings to get a true picture of what’s happening in corporate earnings around the world.

The impact of currencies may not reflect the entire picture of what’s happening in an economy or company operating within it.