By Dr. David Kelly, Chief Global Strategist, J.P. Morgan Funds

In recent months, the rising dollar has become a key theme in financial markets. Currency movements have always been complicated both in their causes and consequences. However, there are relatively straightforward explanations for the dollar surge in 2014. Moreover, while a higher dollar presents challenges for both investors and U.S. corporations, at this time it appears to be a positive force in the global economy and, in the long run, for global investors.

The dollar’s rise, while not extraordinary, is certainly significant. As this is being written, on a year-to-date basis, the dollar is up 8.8% versus the euro, 3.2% against the British pound and 2.4% against the Yen, with almost all of the gains coming since May. A number of factors have likely contributed to the dollar’s ascent.

• First, compared to other major economies, the U.S. is currently displaying the best momentum relative to its trend growth pace. Following a 4.6% real GDP surge in the second quarter, the U.S. appears to have grown by a healthy 3% in the third. This is in contrast to the eurozone, China and Japan which, while not in recession, have shown signs of relative stagnation over the summer. Traditionally, fast-growing economies have rising currencies due to capital inflows.

• Second, the Federal Reserve looks set to increase interest rates in 2015, unlike either the European Central Bank or the Bank of Japan. All other things being equal, investors like to hold their assets in whatever currency pays the highest short-term rates. While short-term rates are close to zero across the developed world today, expected rate hikes from the Federal Reserve should change this over the course of 2015. If investors expect the dollar to be in favor then because of higher rates, it makes sense to buy dollars today to take advantage of the expected appreciation.

• Third, the shale energy revolution is having a major impact in reducing the U.S. trade deficit. To put this in perspective, in 2005, the U.S. consumed 20.8 million barrels of petroleum products a day, of which 12.5 million or 60% had to be imported. In 2013, we consumed 19.0 million barrels, of which 6.6 million or 35% were imported. By 2015, according to Energy Department estimates, we will consume 19.1 million barrels, of which just 4.1 million barrels or 21% will be imported. In other words, while the long-term trend is startling, even the increase in domestic production between 2013 and 2015 could save 2.5 million barrels per day which, at $90 a barrel, would cut roughly $80 billion from a $480 billion trade deficit—this is a clear positive for the U.S. dollar.

It is very important to note that all of these factors should, by now, be imbedded in exchange rates. In theory, U.S. dollar movement from here depends not on these trends but rather on any further surprises in growth, central bank policy or trade numbers. We may well get such a surprise from more aggressive Fed tightening than the market expects. However, it would be unwise to make too big a bet on further dollar appreciation on the tenuous assumption that the Fed turns more hawkish.

Having said this, the dollar move so far has and will have some important impacts on the global economy and investment environment.

The most obvious effect, so far, is a negative impact on international investment returns. For example, on a year-to-date basis, by the end of September, while the MSCI EAFE index of developed country international stocks was up 4.5% in local currency terms, it was down 1% measured in U.S. dollars.

A second problem is the impact of a rising dollar on the earnings of U.S. companies with large foreign operations. In 2012, of the S&P 500 companies that provided details on foreign sales, almost 47% of total sales came from abroad. While this probably overstates the importance of foreign sales for the S&P 500 overall, clearly a higher dollar, which cuts the dollar value of international revenues, is a drag on earnings. On average in the third quarter, the major currency U.S. dollar index was up just 1.8% year-over-year, so the impact of a higher dollar on third-quarter earnings should not be too significant. However, even if the dollar were flat for the rest of the current quarter, the dollar index would still be up 6.7% year-over-year for the fourth, suggesting a more significant drag on profits. Nevertheless, even with this, solid GDP growth combined with only slowly rising interest rates and wage growth should deliver mid-single-digit profit gains for the rest of this year and next.

On the positive side, a rising dollar is cutting import prices in general, which should help hold inflation in check. In addition, as is often the case, oil prices seem to be reacting more than would seem logical to the dollar movement. Over the past year, while the dollar index has risen by 7.2%, WTI crude oil prices have fallen by 16.8%. By feeding through to lower gasoline prices, this boosts the real disposable income of the average American household, a long-overdue bonus in what has been a very unequal economic recovery. In addition, while markets fear the advent of Fed rate hikes in 2015, the reduced inflation pressure from a rising dollar may allow the Fed to start later and raise rates more slowly than would have otherwise been the case.

Most importantly, however, a higher dollar effectively transfers demand from the U.S. economy to economies around the world. At this stage of the global business cycle, this is a welcome development. The U.S. unemployment rate is now below its 50-year average and falling fast, highlighting the limited remaining capacity for the U.S. economy to absorb extra demand without generating inflation. By contrast, other economies such as Japan, emerging Asia and Europe could do with a boost to their exports, which should be the result of a higher dollar. In the long run this should lead to a healthier, more balanced global economy.

Investment decisions should always be made with an eye to the future and it is, as always, very difficult to forecast the direction of the dollar from here. However, the rise in the dollar so far in 2014 will have impacts well into 2015, and those impacts should be generally positive for the global economy and risk assets in both the U.S. and around the world.

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