A key concern among macroeconomic market participants has been the strong US dollar, with some viewing this as a negative catalyst towards the domestic stock market. This might not be the case, analysis from Capital Economics says. Looking at history since the 1970s, the report noted it was a rarity when a strong dollar by itself caused a stock market decline. Is this time different?

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Can a strong US dollar and a strong stock market co-exist?

Since the election of Donald Trump the dollar has surged to a thirteen year high. While some market analysts suggest dollar strength will derail the S&P 500 – where most of the largest multi-national corporations reside — Capital Economics looks at and thinks the stock market might have marginally more room to run in 2017.

“But a strong dollar and a strong stock market can co-exist in the right circumstances,” report author John Higgins concluded in a November 25 piece titled “How vulnerable is the US stock market to the strong dollar?”

The big question is: are we in a period of “the right circumstances?”

Strong US dollar – Currency prices are not always a driver of stock market value

Looking at history, it hasn’t been the US currency that has driven stock prices to the same degree as other macroeconomic events. The relative price of a sovereign currency is driven, in part, by the strength of the regional economy and interest rates. In fact, all three sovereign economic factors – interest rates, currency values and economic strength – are highly correlated.

“Admittedly, a strong dollar was accompanied by a weak stock market in the first of only four periods since the early 1970s when the US currency has appreciated significantly,” Higgins observed.

Another period of dollar strength leading into the turn of the century was preceded by a stock market fall.  During this period monetary policy was “somewhat supportive” for the greenback, as the mid-1990s through the early-2000s was a period of US economic strength. Consensus thinking was rapid technological progress had ushered in a new era of permanently faster productivity growth that justified much higher equity prices – “this time it’s different” thinking. That bubble was burst in the beginning of the new century as the stock market fell dramatically but the US dollar didn’t start to fall until later.

US dollar fall preceded 2008 global financial crisis

The “tech wreck” stock market decline in 2001 was followed by a steep decline in the dollar that led into the 2008 global financial crisis. During this period, the dollar fell before while the stock market held steady until the financial crisis.

Then the third period of US dollar strength resulted in stock market weakness from April 2008 to March 2009, but that recovered as US central bankers loosened policy in the wake of the “Great Recession.” In fact, what prompted US dollar strength was the perception of the world’s reserve currency as a safe haven amid a world concerned about a global financial catastrophe exacerbated by non-cleared derivatives.

The stock market picked itself and moved higher, but it wasn’t until 2014 that the US dollar started to gain strength – and has significantly outperformed the stock market since. This move in both stocks and the US dollar was driven by expectations of a strong economy amid a loose monetary policy.

Strong US dollar – What will happen to the dollar and stock market in unconventional era?

So in light of negative interest rates in Europe and Japan – a monetary policy without historical precedent – and rising rates in the US, how might US stocks fair during this period?

Higgins thinks the S&P 500 will struggle during periods of dollar strength as profit margins on multinationals will be squeezed. Given this, the index will move higher, touching 2,300 next year and providing investors nearly a 4% return.

The analysis is based on the continued expectation of US economic strength, with increasing forecasts of GDP growth next year dependent on Trump’s much-ballyhooed prospect of a big fiscal stimulus.

While some factors are entirely new in this period – the withdrawal of unconventional monetary policy, for instance – while other factors driving markets remain the same.