With everyone trained to look at the same sales figures and gross domestic product (GDP) numbers, it is always useful to find new ways to project a company's earnings or a country's growth rates. For equity investors, foreign exchange fluctuations can mean the difference between a profitable quarter and an unprofitable one, while for currency traders, equity movements can help to determine whether the overall market is seeking risk or avoiding it. With this information, traders and investors can get a better understanding of the close relationship between these two markets and also gain an added advantage in forecasting market direction.

SEE: The Forex Market: Who Trades Currency And Why

The Impact of Currencies on Equities
There are many ways in which currencies can impact equities. For multinational companies, currency fluctuations can increase or reduce foreign earnings. For importers and exporters, exchange rates can impact profitability and sales. Let's take a look at how these relationships work.

Relative Performance Between Industry Peers
Currency fluctuations can mean the outperformance or underperformance of industry competitors. Take Boeing and France-based Airbus for example; the companies realized a divergence in profitability between 2006 and 2007 when the euro appreciated 20% against the United States dollar. Boeing, the U.S.-based airplane manufacturer, saw a sharp rise in orders for its Dreamliner jet. There was a notable shift in interest by foreign buyers once the euro rose from 1.18 to 1.42. Boeing's European competitor, Airbus, on the other hand, suffered greatly due to the strengthening euro. In the third quarter of 2007, Airbus announced that it would be cutting 10,000 jobs and accelerating production of a new super jumbo jet to reverse an $810 million loss.

Importers Vs. Exporters
Currency strength or weakness can also mean the difference between one sector underperforming another. More specifically, when the U.S. dollar weakens, companies like Wal-Mart, which imports most of its products, underperforms companies like Boeing, which sells a lot of its jets abroad. In Figure 1, the orange line represents the dollar index while the blue line represents the price of Wal-Mart divided by the price of Boeing. As you can see, when the U.S. dollar weakens, Wal-Mart underperforms Boeing and when it strengthens, Wal-Mart outperforms Boeing. The reason for this is that a stronger greenback means that companies like Wal-Mart have greater buying power, making the cost of foreign goods less expensive.

Figure 1:When the U.S. dollar weakens, Wal-Mart underperforms Boeing and when it strengthens, Wal-Mart outperforms Boeing.
Source: DailyFX.com

International Exposure
For multinational corporations, doing business internationally can be a good or bad thing. If your local currency is weakening, foreign exchange fluctuations will boost foreign earnings; if your local currency is strengthening, currency fluctuations could reduce earnings. The period between 2002 and 2007 was one of U.S. dollar weakness. Take McDonald's for example; the advantage that the company's quarterly earnings received from the foreign exchange conversion given their international exposure cannot be dismissed.

SEE: Forex Trading Rules

In 2007, Aegis PLC, the British buyer of advertising space, reported an 18% drop in the first-half profits because of negative currency movements. The U.S. dollar fell 10% against the British pound in the first six months of the year, while the euro fell 1.8%. This adversely affected profits from U.S. and European sales. Companies based in Europe, the United Kingdom and even Canada were feeling the pinch of a lower U.S. dollar as the value of larger contracts with producers suffer when profits are converted back.

Merger and Acquisition Targets
Sharp currency fluctuations can also lead to an increase in cross-border mergers and acquisitions (M&A). When the Canadian dollar hit a 31-year high in 2007, Canadian companies went on a buying spree. It was not hard to understand why, given that the currency increased 62% between 2002 and 2007. This increase raised the market share of Toronto-Dominion Bank, Canada's third largest bank (as of October 2007) to more than $52 billion, allowing it to announce plans to buy U.S.-based Commerce Bancorp for $8.5 billion. The deal was structured as 75% stock and 25% cash. If TD had engaged in the transaction six months prior to the announcement, when the USD/CAD was trading at 1.16, the deal would have cost $1.3 billion more Canadian dollars, or a premium of 14%.

Canadian banks have announced or completed billions of dollars' worth of cross-border acquisitions in 2007. Currency fluctuations clearly impacted cross-border M&A and it is not uncommon to often see this trend when companies, in countries with currencies that have increased significantly in value, spend their newfound wealth.

The Impact of Equities on Currencies
The strongest relationship that we have seen between equities and currencies is the relationship between carry trades and the Dow. In 2007, you can see many currency pairs that can be categorized as carry trades. The most popular of these are the New Zealand and Australian dollars paired against the Japanese yen. With interest rates at 50 basis points in 2007, the yen became an extremely cheap funding vehicle, not only for investments in higher yielding currencies but also for investments in equities. When the Dow rallies, it tends to reflect a growing willingness of traders and investors to take on risk. Countries that offer higher interest rates do so because they generally have higher risk or lower sovereign debt ratings. That is why both the Dow and carry trades are a measure of risk. This relationship is not foolproof, but generally speaking, when there are sharp gains in the Dow, carry trades tend to rise as a reflection of growing risk appetite. When the Dow collapses, carry trades on Japanese yen crosses will sell off as a reflection of rising risk aversion.

Figure 2 illustrates the close relationship between the Dow (candles) and carry trades (black line) between 2002 and 2007. In this example, the carry trade index is tabulated as a basket composed of the three highest yielding currencies against the bottom three low yielding currencies that are updated daily over 17 years using three-month LIBOR rates for each country. For our universe of currencies, we used the majors (EUR/USD, USD/JPY, GBP/USD, USDC/HF) as well as the commodity dollars (USD/CAD, AUD/USD, NZD/USD).

Figure 2:The close relationship between the Dow (candles) and carry trades (black line) between 2002 and 2007.
Source: DailyFX.com

Carry trades can and will deviate from equity market returns in the short term, and traders should not necessarily assume that if the Dow rises, carry trades will rise simultaneously. However, what Figure 2 does illustrate is that over the medium term, carry trades and equities are very much correlated. The reason why this is the case is because in its purest form, the carry trade is essentially the never-ending hunt for yield by global investors. When the carry trade performs well, it creates excess returns not only in the form of higher yields but sometimes substantial capital appreciation as well. These excess returns generate a massive amount of capital, which seeks more speculative returns and often find its way to the equity market.

The opposite is true as well where strong stock market gains attract more participants into the market. In order to initiate or increase exposure, many foreign investors, especially those on the hedge fund level will borrow against low yielding currencies like the Japanese yen and Swiss franc to leverage their investments in U.S. equities.

The Bottom Line
Ultimately, foreign exchange is here to stay and will continue to affect companies and the bottom lines in quarters to come. The importance of this relationship continues to grow as companies look over the horizon at global markets and competitors, and expand beyond the U.S. into countries like Europe and Asia. The result leaves sales and product lines exposed to foreign exchange risk. As a result, with everyone in the stock market looking at the same thing, it may very well pay to look outside the box and turn to the currency market as a harbinger of future earnings. Ultimately, this may give the average investor a leg up in a market bent on similar interpretations.

SEE: Economic Indicators

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