After a promising beginning to 2014, the American stock markets began stumbling in autumn: The S&P 500 had gained 9.3 percent through the beginning of September, but dropped by 7 percent between then and mid-October. On October 15, the S&P briefly fell into negative territory for the year, giving back all the year’s gains. One of the reasons given for these losses was the poor economic news coming out of Europe. Germany, the acknowledged financial leader of the European Union, slashed its growth forecast, raising fears it might dip into recession again.
Is it possible that fears of another downturn in Europe could have such a strong effect on American stocks, or was there something else going on? Coincidentally, the National Bureau of Economic Research released a paper in October called “Stocks, Bonds, Money Markets, and Exchange Rates: Measuring International Financial Transmission” that addressed this very question. The answer is fairly simple: Yes, global markets are interconnected to the extent that even investors in just domestic stocks would do well to pay attention to what’s going on in Europe, and around the rest of the world. In fact, in the global village, it’s a necessity.
One of the big reasons that Europe’s woes are affecting us is the rising value of the dollar – something Americans generally cheer. For the six months that ended at the beginning of October, the value of the dollar was up 9 percent versus the euro. That reduces the profits earned by American goods sold in Europe, and increases the profits earned by European companies.
The companies in the S&P 500 derive an average of 13 percent of their revenue from Europe – the most of any region other than North America. The giant consulting firm Accenture, for instance, gets less than half its revenues from the U.S. The semiconductor manufacturer Qualcomm gets a whopping 97 percent of its sales from abroad. The strong dollar hurts the bottom line for businesses like that, and a global downturn would have a huge impact on their profits.
Research proves that stocks around the world, by contrast, benefit from a stronger dollar. The MSCI World Index, a basket of global stocks that includes 22 countries plus the United States, has risen 72 percent of the time during periods of dollar strength since 1980. That’s 10 percentage points better than it’s performed during periods of dollar weakness.
It’s important to remember that Europe is also a fulcrum for the rest of the world. China is the world’s biggest exporter, having passed the U.S. in that distinction in 2012, and the number one customer for its goods is Europe. If Europe slides into recession, that will affect China – and the rest of the world along with it.
The paper from the National Bureau of Economic Research put a figure on all of this: It found that about 8 percent of U.S. financial market shifts are caused by European developments. That’s a pretty significant figure, but Europe is much more affected by our economy than the other way around. On average, about 26 percent of movements in European financial assets, the NBER reports, are attributable to developments in U.S. financial markets.
There are ways for savvy investors to play the strength of the dollar and the economic weakness in Europe. According to research from Credit Suisse, the types of stocks that have performed best during times when the dollar was strong include food retailers, pharmaceutical companies, makers of construction materials, banks and insurance companies. Companies that export goods tend to do the worst when the dollar is strong, with metal and mining stocks being by far the weakest performing group.
Among the ten sectors that make up the S&P 500, four of them actually derive more than half of their sales from overseas markets: Information technology, consumer discretionary, consumer staples and energy. But two sectors, telecommunications and utilities, derive no overseas revenues at all.
So it’s not inevitable that a European downturn must necessarily have a negative effect on an American investor’s portfolio. By monitoring the global situation and making savvy decisions, it’s possible to protect your assets from even a rough overseas economy.