PepsiCo (NYSE:PEP) recently announced fourth quarter and full-year results with net revenue down 5% to $63 billion and diluted earnings per share down 14% to $3.67. But the real story is found in the bleak portrait of global economic malaise as painted by Chairman and CEO Indra Nooyi:
Over my several decades in business, I have never seen this combination of sustained headwinds across most economies, combined with high volatility across global financial markets. From our meetings and observations traveling around the world, I've noted slow economic growth or recession across all but the US and a few other countries as a combination of geopolitics and oil have created many challenging economic outcomes.
These forces are putting "extreme pressure on previously booming economies like Russia, Canada and Brazil ... " and the rebound, according to Nooyi, may be a long slog as the few tools possessed by the central banks in these economies have been "fully exploited over the past several years".
She goes on to describe how this global turbulence may impact the U.S. and upend its economy, stating that the U.S. is experiencing a delicate recovery that may falter if the "globe continues to experience such massive pressures". Specifically, she points to three risks to the U.S. economy: the strong dollar, volatile financial markets, and widespread political and social turmoil. The question is: How intense are these pressures?
A robust greenback
First, the widespread economic malaise has created a strong U.S. dollar, which has the effect of creating local inflation in international markets and threatens to derail the U.S. economic recovery. -- Nooyi
The strong U.S. dollar creates both a transaction and translation problem for domestic companies with large overseas markets. The transaction issue occurs as products with dollar denominated source inputs retain their pricing power to account for costs. Subsequently, the product is more expensive in markets with weaker currencies, and therefore, local consumers purchase less.
Secondly, the translation problem occurs when revenues are exchanged back from a weaker currency to the stronger dollar. In China for example, the yuan has been notoriously devalued and now stands at a five year low to the dollar. One million yuan renminbi would have translated back to roughly $165,000 in early 2014. Now, the same amount of renminbi would only exchange for $153,000.
Any domestic companies with significant overseas exposure in countries with weak currencies such as China and its daisy-chained Asia Pacific economies will realize these headwinds are driving revenue and earnings hits. This can lead to restructuring layoffs which can impact the economy even more broadly.
According to data published by the S&P Dow Jones Indices in July of 2015, approximately 48% of S&P 500 company revenues come from international markets.
Volatile financial markets
Second, volatile financial markets may cause a pullback in corporate investment and consumer spending. -- Nooyi
Markets across the globe have been erratic with the U.K. and Japan entering bear market territory in January, in addition to multiple circuit breaker fumbles made by the Chinese government in its attempts to half market sell-offs. In the U.S., the Dow is down approximately 4% year-to-date, and although U.S. economic fundamentals appear to be sound, market sell-offs can become an economic self-fulfilling prophecy.
As markets decline, additional sell-offs occur, and the cycle continues. Timothy Geitner likened this behavior to an E. coli meat scare in his book Stress Test, except in this case, as more consumers avoid the meat, the more E. coli it creates. As markets decline, flights to safety take place, and this typically pushes bond rates down. But yields on bonds issued by energy companies and others have risen lately, precipitated by perceived risk.
As bond rates increase, the costlier it becomes for businesses to make current investments, because the discount rate on future profits has increased. Thus, business investments tend to seize up. According to Stanford University economist Bob Hall, "a falling stock market often coincides with rising unemployment, because both reflect higher risk aversion and discount rates," as cited by Wall Street Journal Chief Economics Commentator Greg Ip.
Ip further elaborates on the ephemeral market psychology that can lead to very real economic impacts:
Economic turning points are unpredictable, because they are caused by changes in psychology, not just mechanical factors such as interest rates and wages and salaries. Markets influence that psychology by signaling to businesses whether they should invest or hire. Fear of recession can thus be self-fulfilling. -- Greg Ip
And, finally, the continued weak economic performance is causing widespread political and social turmoil across the globe, which may create even greater economic harm. -- Nooyi
During the conference call, Nooyi points to the Middle East as a source of geopolitical unrest with its refugee crisis and militant dynamics, but political volatility is rife in other regions as well: The U.K. is deciding if it wants to leave the European Union, and subsequently, Scotland may leave the U.K. In the U.S., the odds are increasing that voters will elect a populist president with a platform of radical economic change. Markets hate uncertainty, which can lead to sell-offs (see self-reinforcing market psychology impacts above).
The picture of global economic malaise painted by PepsiCo CEO Indra Nooyi is troubling to say the least, and Nooyi made some important links to the U.S. economy during the call. Specifically, she formed a contagion path to the U.S. through the strong dollar, volatile financial markets, and geopolitical unrest and uncertainty.
If the intensity of these pressures keeps up, they will potentially derail the U.S. economy. What is the likelihood of this happening? Approximately half of S&P 500 revenues come from international markets; market confidence is shaky at best; and Donald Trump just won 46% of the Nevada Republican primary votes. The probability is high, to say the least.
Adam Brownlee has no position in any stocks mentioned. The Motley Fool owns shares of and recommends PepsiCo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.