Currency Battle Could Start Hurting Corporate Earnings

The ongoing global currency battle is likely to begin eating into earnings as companies struggle to find ways to hedge against unpredictable moves in various denominations.

Currency Signs
Currency Signs

As earnings season officially kicked off Thursday with Dow component Alcoa, investors started to get a glimpse of how devaluations of the US dollar and other global currencies will play out.

Though Alcoa posted better-than-expected profit and revenue for the third quarter, CEO Klaus Kleinfeld told CNBC that currency volatility was having a negative impact on the aluminum company's business.

"That's exactly the issue that we had this quarter in the upstream business," he said. "We had a very strong headwind coming from currency. The weakening of the dollar, and the strengthening in this case of the Australian dollar and the Brazilian dollar, given that most of our production is there, hit us severely."

When delivering earnings, most companies will offer generalized statements about how hedging strategies worked against currency volatility. But with such uncertain times ahead as central banks pursue a global race to the bottom, such statements may require a bit more proof.

"Multinationals have operations overseas and that plays into this because they're not just dealing with the dollar, they're dealing with a basket of currencies," says Quincy Krosby, strategist at Prudential Financial in Newark, N.J. "The story becomes even more complex if we're in a scenario in which many countries are trying to weaken their own currencies vis-a-vis each other."

The impact of currency volatility probably will not show up significantly in third-quarter earnings, which are expected to show gains of about 24 percent. Rather, the key will be outlook, in which firms will try to estimate the impact that currency movements will have on future earnings.

Even then, investors will have to watch closely as individual companies will gain or lose depending on whether they do must of their business nationally or internationally, and in what nations and how those currencies stack up against the greenback.

Hedging strategies, meanwhile, may not be as effective in the past because of the multitude of foreign banks expected to devalue and the volatility that will cause.

"It hurts everybody because of the uncertainty. You don't know what to do," says Howard Silverblatt, senior index analyst at Standard & Poor's. "You can hedge against manufacturing but you can't against sales."

Also making the matter difficult for investors is that companies don't break out data on currency impact, so the only real gauge is outlook comments.

"You're stuck with guidance, which is going to be general," Silverblatt says. "The companies that have reported so far have been gearing it down to lower expectations, which would be normally what you would do if you're going to take a hit."

Currency issues are likely to hit hardest on information technology, which makes up the biggest earnings contribution to the S&P 500 index, he adds.

"Everything is in a relationship," Silverblatt says. "If I'm making it in India then using competing parts in the UK and selling it in Europe, I've got four different currencies. So it gets a lot more complicated, and companies do not give you that matrix. You've got to go by their guidance, and the guidance has been down a little."

Hedging is a curious thing by itself.

When the strategy works well it can do wonders for corporate bottom lines, but when it doesn't it can cause huge problems. Cloudiness from currency only exacerbates the challenge.

"First, not everybody does that. Second of all, they may not have hedged enough," says Uri Landesman, who heads the Platinum Partners hedge fund in New York. "It's hard for me to believe that everybody was hedging against an 82.44 yen. Also, hedging is not inexpensive. Some people do a better job than others."

As for the effect of cheaper currencies, the effects in the marketplace are contradictory.

The stock market and US dollar have been riding a largely inverse relationship all year. When the dollar falls, stocks almost instinctively rise, and vice versa.

But once the currency effects play out, investors may find that a cheap dollar isn't quite the road to prosperity it was cracked up to be, particularly for multinationals.

"All things being equal as long as demand remains intact globally, the weaker dollar should benefit the bottom line of those companies," Krosby says. "The other part of the story is the weaker dollar is then going to push up the prices for commodities."

So over the long haul, the cheap dollar actually can become a headwind for company growth, especially in commodity-sensitive businesses, which encompass a wide swath of the S&P 500.

"Without question it's probably going to become an issue sooner rather than later," says Ryan Detrick, senior analyst at Schaeffer's Investment Research in Cincinnati. "The stock market seems to like the race to devalue currency. But there will be a time when you will have to pay the piper."

In such an environment, trying to fend off currency challenges and keep profits looking good is bound to be increasingly challenging.

"It's becoming much more difficult for companies to have a longer-term hedging strategy," Krosby says. "Hedging strategies have to be much more complex in this environment, much more sophisticated with this backdrop of countries designing paths for weaker currencies."