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  • The U.S. Dollar Index has significantly outperformed this year.
  • Multinationals face a profit headwind as they convert foreign currency sales back into U.S. Dollars.
  • 3 technology stocks with big international exposure.

Bitcoin wasn't "the hedge" against inflation. Neither was gold. Instead, it's been the U.S. Dollar. 

Runaway inflation resulting in the fastest pace of rate hikes in decades and global recession fears causing a flight to safety have resulted in stellar performance for Invesco's DB US Dollar Index Bullish Fund ETF  (UUP)  this year.

The Dollar ETF, which tracks the U.S. dollar relative to the Euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc, is up 12.5% year to date, which is about 33% better than the S&P 500. Although the S&P 500 has lost 16% since March, it's up 9.6%. 

That's some significant outperformance. However, there's a downside. The Dollar's strength relative to other currencies is making it harder for multinational companies to compete against overseas competitors. Moreover, it dings earnings when sales in foreign currencies get converted back into U.S. Dollars.

According to Credit Suisse, U.S. company profits fall 1% for every 8% to 10% lift in the U.S. Dollar. As a result, increasingly more high-profile companies are citing U.S. Dollar strength as a big headwind. According to Bloomberg, 218 S&P 500 companies mentioned currency exchange in their first-quarter earnings calls. That's the most in three years. Given the Dollar's recent strength, it wouldn't be surprising if more companies blame currency exchange for lackluster results in their second quarter calls, which begin in earnest next week.

3 Technology stocks with currency risk

According to Real Money Pro's Ed Ponsi, Microsoft  (MSFT) , Alphabet  (GOOG)   (GOOGL) , and MongoDB  (MDB) , are among the companies that could feel the sting.

In "A Strong Dollar Could Undermine These 3 Stocks With Massive Overseas Revenue," Ponsi explains each of these companies derives a substantial amount of revenue overseas, exposing them to unfavorable currency conversion risk.

He writes, "Over the past year the U.S. dollar has been one of the hottest currencies in the world. This week alone, the greenback reached a 20-year high against the euro and a 2-year high against the Japanese yen...U.S. companies that enjoy robust sales overseas are the ones most likely to suffer a negative impact."

Microsoft already warned currency is going to be a problem. On Jun 2, the company said currency exchange will negatively impact its fiscal fourth quarter ending June 30. 

Ponsi writes, "In early June, Microsoft warned that the strong dollar could subtract $460 million from its revenue. Since then, the dollar has exploded higher, gaining an additional 6.7%. That's a big move in the world of currencies."

The drag caused by U.S. Dollar prompted Microsoft to lower its earnings per share outlook for the quarter to at least $2.24 from its prior outlook of $2.28. Although Microsoft hasn't issued additional guidance, it could be hard to deliver on analysts' estimates. Currently, the consensus expectation is Microsoft will report EPS of $2.30 this quarter, according to Yahoo!Finance data.

The risk to Alphabet similarly stems from the fact it generates a lot of its revenue abroad. 

Ponsi writes, "According to statista.com, only 46% of Alphabet's revenue is generated in the U.S. while 30% comes from Europe, the Middle East, and Africa. This has been the case for at least the past seven years."

In Q1, Alphabet reported sales growth of 23%, which was 3% lower than it would've been if currencies had remained constant. It's not the first time Alphabet's financials have faced stiff currency headwinds either. A strong Dollar lopped 6% points off its revenue growth (about $600 million) in Q1 2016.

MongoDB is a much smaller company, but it nets significant revenue from foreign markets that could pressure its results too. According to Ponsi, the "Enterprise software maker receives about 40% of its revenue from overseas."

Of course, these are just three examples. Many companies pocket at least as large a percentage of revenue globally as do Microsoft, Alphabet, and MongoDB. For instance, Salesforce lowered its fiscal '23 revenue outlook in May by $300 million because of the Dollar's strength. 

And it's not just technology stocks that are at risk. According to Bloomberg, roughly 35% of U.S. companies do enough business overseas to put them at material risk from foreign exchange rates. Moreover, 29% of all S&P 500 revenue is generated outside the U.S. market, according to Goldman Sachs. Clearly, this isn't an isolated headwind.

The Smart Play

It isn't lost on investors that the Dollar's strength is hamstringing multinationals. Companies that primarily do business in the U.S. were outperforming those with more international exposure by nearly 10% this year, according to a report issued by Goldman Sachs in June. This suggests that if Dollar strength persists, investors may want to focus on U.S.-centric ideas for now.

The Dollar's strength makes meeting analyst targets more challenging, so we may see more earnings misses than last quarter. However, currencies are volatile, so most investors shouldn't extrapolate the Dollar's strength too far into the future.

Historically, mean reversion causes currency headwinds to eventually shift to tailwinds. As a result, most investors should view currency risks as a short-term problem, rather than a reason to discard a long-term thesis. To put it another way, how a company executes its long-haul growth strategy is much more important than currency fluctuations.

If you're an active investor, avoid the temptation to buy ahead of EPS reports hoping for a pop, particularly in large-cap technology stocks. Instead, lower exposure by selling on up days, particularly if the stock is overweighted in your portfolio. There's little reason to gamble on earnings day during a bear market.

It may also make sense to consider owning the UUP ETF or if you think the Dollar's move has gotten ahead of itself, shorting it. Alternatively, if you think the sell-off in the Euro is overdone, you could buy Invesco's Currency Shares Euro Trust (FXE) with a stop loss.

Long-term investors should watch how investors react to earnings this season. In recent quarters, stocks have sold off following both good and bad news. If that reverses, it could be a good sign. You'll also want to read your company's earnings call transcripts to learn how they're thinking about currency for the third quarter and through the end of the year (a quick control "F" for currency makes doing that easier.) Between decelerating economic activity, rising input costs, and Dollar headwinds, we may see this become a "kitchen sink" quarter, as management significantly undersells guidance through year's end to make it easier to exceed expectations later on.

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