Dollar Surge

Sydney, Feb 29, 2008 (ABN Newswire) - The Aussie dollar is off again, charging towards parity with the sinking US dollar (or is it more a case of the US dollar falling towards us?)

But after hitting a low just above $US0.85 late last month, the currency is now up sharply at more than 94 US cents yesterday.

In fact the Aussie is now back over the November high of $US0.94 and close to 95 USc Friday morning, its highest level in nearly 24 years.

The AMP's Chief economist and strategist, Dr Shane Oliver examines the implications for investors of this run up.

The $A, interest rates and global growth

The latest surge in the $A reflects a combination of expectations for a further widening in the interest rate differential between Australian and global interest rates, renewed strength in commodity prices and renewed weakness in the $US. Whereas Australian interest rates are still rising they are falling in the US and have most likely peaked in Europe and Japan.

And the strength in commodity prices is evident in everything from oil to wheat.

While economic growth is slowing rapidly in rich countries, in the emerging world it is still strong and this along with constrained supply is helping to keep commodity prices strong. As such the ongoing strength in the growth sensitive Australian dollar is telling us that global growth is slowing, but it is not collapsing, at least not yet anyway.

How far can the $A go?

Traditional valuation measures for the Australian dollar constructed over the period since the currency floated indicate that it is overvalued. For example, our measure of fair value for the $A, based on the assumption that the exchange rate should move to equate average price levels across countries, suggests a fair value level of around $US0.70. (See the next chart).

But measures of value for exchange rates are of little relevance most of the time given the tendency of currencies to overshoot. More importantly they may be even less useful for the $A when the secular trend in commodity prices goes from down to strongly up as has been the case since earlier this decade.



The outlook for ongoing strength in commodity prices suggests that the rising trend in the $A still has further to go.

Our long term view remains that commodity prices are in a secular upswing driven by relatively constrained supply and surging demand from China and other emerging countries and that this will run for at least the next decade as the industrialisation process in such countries has a long way to go.

This has certainly been evident lately with oil breaking through $US100 a barrel, gold above $US950 an ounce, record prices for some soft commodities, copper moving up to retest its May 2006 high, 65% or so increases in contract prices for iron ore and likely 80% gains in contract coal prices.

Increases in contract iron ore and coal prices are likely to roughly eliminate Australia's trade deficit over the next year.

The strength in commodity prices already suggest the $A should be above parity to the $US (see chart below) but of course investors have been slow to price this in because of ongoing scepticism about the sustainability of high commodity prices. This scepticism seems to be fading.



The strength in commodity prices highlights the problem with trying to find a fair value for the $A just based on the period of history for which the Australian dollar has been floating (since December 1983) because the last time Australia's terms of trade (export prices to import prices) was at current levels in the early 1950s one Australian dollar bought 1.12 US dollars. (Australia's strong terms of trade points to a higher $A)

Along with a continuing broad based decline in the $US, a widening interest differential is also adding to the upwards pressure for the $A at present.

The gap between US and Australian interest rates is currently 4% and is set to widen further, probably to around 5 to 5.5% by mid year as the Fed continues to cut US interest rates and the Reserve Bank raises Australian interest rates a couple more times.

The gap between Australian interest rates on the one hand and European and Japanese interest rates on the other is also likely to widen further with rates in both countries likely to have peaked for now.

These considerations suggest the broad trend in the $A will remain up. Having broken through last year's high of $US0.94 to its highest level since early 1984, the Australian dollar now looks like it is on its way for a test of the 1984 high of $US0.9653 and beyond that a run to parity against the $US, possibly in the next few months.

Just as the $US100 a barrel level proved to be a point of attraction for speculators and traders in oil recently, parity is likely to be a similar point of attraction of speculators in the $A. (Investors are just as affected by "roundaphobia", or the obsession with round numbers, as everyone else.)

However, while the secular trend in the $A is still up and parity may soon be reached versus the $US, the ride for the $A is unlikely to be smooth over the next year.

Periodic bouts of growth worries are likely to hit shares and commodities over the next six months and this will see pull backs in the Australian dollar just like we saw in August last year (when the $A fell back below $US0.77) and in January this year.

A high level of speculative activity in many commodities also leaves them vulnerable to a short term pullback. (It seems that investors have piled into commodities because they are the only asset with still clear positive momentum.)

Through 2009, the $A may come under some pressure as Australian interest rates top out and probably fall as local growth slows at the same time as US/global growth starts to improve resulting in upwards pressure on interest rates in the rest of the world.

The impact of a rising $A on the economy and shares

The strong $A is good news for Australian consumers as it will mean lower prices for imported items. Imports account for nearly 30% of consumption goods, e.g. cars, clothing and many electrical goods. So the latest surge in the $A may help take some of the pressure off inflation and interest rates.

Unfortunately, it is unlikely to prevent another rate hike or two over the next few months and in any case the RBA would be aware that the strong $A through last year had less of a dampening impact on inflation than would normally have been expected.

For the broader economy and share market, the ever stronger $A is bad news as it comes at a time when rising interest rates are already threatening Australian economic growth and business confidence is starting to slide.

It is much easier to identify companies that will lose from a rising $A via the impact on their earnings (such as resource, multinational industrials and building material stocks) than to identify companies that benefit because of lower import costs (e.g. retailers and airlines).

With 30% or so of listed company earnings sourced overseas, a 10% rise in the $A will mechanically cut earnings by about 3%.

If the $A continues to rise it will only be a matter of time before trade exposed companies start to see another round of earnings downgrades, much as we saw around October/November last year when the $A first hit $US0.90.

The continued strength of the $A is worse for large cap shares, which have greater foreign exposure, than small caps, which often benefit from cheaper imports.

As can be seen in the next chart a strong $A normally sees small caps outperform large caps.



Companies are particularly vulnerable in situations where there is no natural hedge to the strong $A, such as multinational Australian building material companies exposed to the US housing slump or the US consumer.

The strong $A and investors

Unhedged international investments leave investors at the mercy of changes in the $A. So if the $A rises 10% it knocks 10% off the value of an offshore investment. Hedged investments remove any foreign currency exposure. Global bond and property funds are usually fully hedged, whereas global share funds are usually unhedged.

There are swings and roundabouts from $A moves on investors global equity investments.

When the $A falls it boosts investors' returns from global shares, but when the $A rises as over the last few years it reduces returns.

Back in early 2003, with the $A starting to head up from very undervalued levels and global growth on the mend it was very easy to justify having a minimal exposure to foreign exchange in investors' portfolios.

With the $A now having almost doubled from its 2001 low of $US0.48, it's a lot harder to justify hedging a big proportion of global shares back to Australian dollars.

But with the risks for the $A still skewed on the upside for now, it would seem sensible for investors to maintain a reasonable degree of hedging.

Conclusion

The broad trend for the $A still looks to be up on the back of strong commodity prices, a widening interest differential in Australia's favour and a falling $US.

So while it's no longer as clear as it was when the $A was much lower, it would seem prudent for investors in global assets to maintain a reasonable degree of hedging back to Australian dollars.


 

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