Saturday, October 16, 2010

Log on and get out your card - we touched US$1.0002 overnight

Craig James on our new buying power:

· Parity! Who would have thought it, especially back in April 2001 when the Aussie dollar fell to a record low of US47.75 cents? Back then, Australia was considered an ‘old economy’ – we didn’t have a lot of companies producing the new fangled technology goods. We still don’t. Rather our claim to fame was as an exporter of coal, iron ore, beef and wool. Well the ‘old economy’ is back in vogue as China attempts to hoover up commodities across the globe.

The Chinese-driven Australian economy is in great shape while the tech-intensive United States economy is struggling. The bottom line is that our Australian dollar is relatively strong.

· Two days ago the Aussie dollar didn’t look like hitting parity any time soon as it was struggling to hold US98 cents. But talk of the US Federal Reserve pumping more dollars into its economy, firmer global economic data and greater demand for gold all propelled the Aussie to the fabled parity with the greenback.

· Does parity matter? The simple answer is no. But this is history – no one under 30 has seen this before and those a bit older would still be struggling to remember when the currency was so strong.

· A strong Australian dollar is neither a good or bad thing. It just is strong... And, as always, there are winners and losers. The main winners are consumers, provided with greater choice about where to take their holidays and where to buy their goods. Retailers may win if they are able to pass only some, but not all of the savings, of a stronger currency. The same goes for importers. And businesses win if they are net importers, especially if they need to buy equipment such as computers but don’t have a lot of exports as such.

· The losers include rural producers – they are less competitive on the global stage. Tourism businesses and regions will find it tougher to attract foreign and domestic visitors. Exporters, more generally, find it tougher – manufacturers, film & TV production companies and universities and colleges to name a few.

· In a net sense, the higher Australian dollar acts to slow down the economy. Consumers and businesses buy more imports, exporters find it more difficult to sell goods, while import-competing firms also experience tougher operating conditions.

· When it comes to the sharemarket, it would be nice to neatly wrap up the argument one way or another – is it positive or negative? But in essence it is more complicated. It depends whether companies have insulated (hedged) themselves from currency fluctuations, whether they have ‘natural hedges’ in place, and it depends what else is happening at the same time. BHP Billiton doesn’t protect itself from currency fluctuations, rationalising that if the Australian dollar rises, it is likely to be because commodity prices are rising at the same time. So what it loses on the swings, it gains on the roundabouts.

· A rising Australian dollar is not unambiguously positive or negative for the sharemarket. But it is useful to note that the Australian dollar has tended to rise in line with the US sharemarket in recent years and that, in turn, has positively influenced the Australian sharemarket. But these correlations do change over time.

Is the Australian dollar strong or US dollar weak?

· Well, both answers are right. The Australian economy has the strongest economy of any advanced nation in the world. Australia also has the highest interest rates in the advanced world and close to the lowest level of government debt. Australia is also the biggest beneficiary of China’s industrialisation.

· At the same time, the US economy is emerging from the worst recession since the Great Depression. Interest rates are at zero, but the Federal Reserve is planning to inject even more cash into the economy to prevent the recovery from stalling. Unemployment is near 10 per cent, the budget deficit is near 10 per cent of GDP and an oversupply of homes still exists.

· So in a ‘big picture’, longer-run sense there are grounds to argue that the Australian dollar is fundamentally strong and also good reasons to claim that the US dollar is fundamentally weak. But what about recent trends?

· The Aussie dollar bottomed in early June (June 7) when it fell to US81.50 cents. Since that time the Aussie dollar has risen by around 21 per cent. Clearly these stellar gains in such a short period of time have caused many to question whether the rally is sustainable. That is, how much of the recent gains for the Aussie dollar are due to weakness of the US dollar, and how much reflect fundamentals such as higher commodity prices.

· Unfortunately there is no fool-proof way to work it out. Certainly one of the best ways to assess the changes is to look at commodity prices in both US dollar terms and currency-neutral SDR terms. Since the start of June the Commonwealth Bank commodity index has risen by just over 11 per cent in SDR terms while lifting around 20 per cent in US dollar terms. It’s also worth pointing out that the US dollar index, which broadly measures the strength of the greenback, has lifted by around 13 per cent over the same period.

· These figures suggest that around half of the Aussie dollar gains can be attributed to commodity prices and the other half to US dollar weakness. But when the US dollar is falling, commodities become cheaper in local currency terms for buyers in Europe and Asia. So some of the gain in commodity prices would reflect greater short-term demand for a cheaper product. At the same time, the perception that Aussie interest rates are likely to rise in coming months and our strong economy would also be factors driving the Aussie dollar higher.

· All that we can say with certainty is that while there is indeed a fundamental basis to the Aussie dollar’s more recent gains, a healthy component of the rise reflects a weak US dollar. That point is important when you consider that commodity prices have only risen by 1 per cent over the period since early June.

So where do we go from here?

· Our currency strategists are tipping the Aussie dollar to be at US$1.02 in the March quarter 2011 before easing to US99 cents in June and US92 cents by December 2011.

· Why lower? The thinking is that the US economic recovery will gain momentum in 2011, fuelled by zero interest rates and a mountain of cash. But when the recovery is on a firmer footing, the Federal Reserve will start the process of ‘normalising’ interest rates – that is, getting rates back to more normal levels. As a result the US dollar will gather support.

· But what about the theory that the last 30 years or so have been somewhat of an aberration in the history of the Aussie dollar?. Up until 1982 the Aussie dollar traded above parity, in fact the Aussie pound was above US$2.40 in the late 1920s?

· But we shouldn’t forget the fact Australia is a net debtor to the rest of the world – it maintains a high current account deficit and high external debt. If Australia was to change from a debtor to a creditor nation as a result of industrialisations in China and India then that would be a different question. But Australia’s high external deficit does act as a fundamental barrier to the Australian dollar rising too high against other global currencies.

· The Aussie was last at US$1.01 on July 21 1982; last at US$1.02 on July 1 1982; last at US$1.03 on June 16 1982; and last at US$1.04 on June 9 1982.

What are the implications for investors?

· If the Aussie dollar continues to rise, the Reserve Bank will become more reluctant to lift interest rates. A high Aussie dollar acts to slow the economy so a rate hike would act like a ‘double whammy’ as well as serving to push the currency even higher.

· Investors need to take into account currency influences when assessing prospects for individual companies. But the key point is that the currency it is just another influence. The main driver, as always, for company earnings is what the company does, how it is run and who it competes with. It’s important that investors don’t get too blindsided by focussing on currency changes.