Sent: 19-10-2010 11:03:02
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Return of the Prodigal Currency
For most of the last 100 years, an Australian dollar (or its pre-decimal equivalent) has been worth more than one US dollar. In this sense, we are reverting to a norm punctuated by Australia's relatively poor economic outcomes in the 1970s and 1980s. A stronger dollar attracts investors.
The Australian dollar had a weekend sojourn at parity before returning lower. Many expect this to be simply a delay before a more conclusive move ahead. Traders are buying the currency because momentum seems to be on its side.
Foreign exchange markets are sometimes such a complex mix of influences that trying to discern the direction from fundamental analysis frequently gives over to momentum trading.
Usually, fundamental value analysis applied to exchange rates refers to differentials in inflation rates. A country whose inflation rate is higher than that of another country risks a declining exchange rate. Australia's relatively high inflation rate during the 1980s was one reason for its declining currency.
Through the 1990s, Australia's inflation rate improved significantly and the currency cuts off the inflation risk factor previously dogging expectations about its likely trajectory.
Relative inflation performance may offer a longer term guidepost for the direction of the currency but will not be the only influence in the shorter term. The balance of payments (reflecting the country's need for capital imports to fund its growth), interest rates, the return on capital invested, political risk and business competitiveness will be among the factors playing a role.
There is little doubt that Australia's economic growth and inflation potential has improved greatly since the 1980s. Most recently, its capacity to fulfil the needs of China's raw material users has catapulted its exports to new levels reducing the underlying need for short term capital to support growth. At the same time, Australia is attracting larger quantities of longer term development capital (reflecting future export opportunities) adding to demand for the dollar and putting further upward pressure on the exchange rate.
Interest rate differentials and some expectations of quantitative easing in other advanced economies are also attracting funds into Australia.
Of course, only a part of the movement in the Australian dollar has anything to do with economic conditions in Australia. Economic conditions in the USA (and elsewhere) are also important. Since exchange rates are relative prices, raising the return on capital alone, for example, may not be enough to have an effect. Any improvement here will have to beat out improvements elsewhere before they register in foreign exchange markets.
Which blade of the scissors (foreign or local conditions) cuts the paper in foreign exchange markets is often impossible to discern. Local residents will tend to emphasize those factors most closely linked to their specific circumstances.
For Australian investment markets, any currency appreciation has been controversial primarily because a rising dollar reduces corporate export revenues. The higher dollar also puts additional downward pressure on the profits of import competing manufacturers. In theory, listed companies engaged in these activities will be disadvantaged and markets should reprice them accordingly. Jobs sourced in these industries will probably be lost.
More positively, if business expects such conditions to persist, it will be forced to adjust. More emphasis on cost reductions, perhaps through investment in new technologies, could be expected to make coping easier. Companies going down this road will end up stronger for having had the experience. Over time, their investment attractiveness will have been improved.
The resources industry is the clearest example of how the stronger dollar may not have an unfavourable effect on Australian investment markets.
In theory, a stronger Australian dollar will reduce Australian dollar denominated receipts from commodity exports predominantly priced in U.S. dollars. The higher currency will often be accompanied by higher commodity prices so that the potential loss in profitability may not be finally realized. Nonetheless, a higher exchange rate on its own will result in a decline in profits reported by Australian miners. Markets should cut their valuations and pay less for them.
However, Australia is not an economic island. Australian equity prices are heavily influenced by overseas investors. For many years when the Australian dollar was falling (theoretically supporting Australian earnings), offshore investors saw their market returns eroded by the currency decline. In practice, overseas investors are attracted by a rising currency.
Right now, overseas investors are enhancing their returns from investing in Australian resource stocks through the local currency appreciation. Despite the potential negative earnings impact, the market price of Australian miners is being enhanced by the rising currency as offshore investors renew their attempts to buy. Local investors will most likely join in.
Subsequently, any tightening of policy by overseas monetary authorities, reducing the relative attractiveness of the Australian currency, will signal downward pressure and, even as Australian dollar earnings begin to rise, market prices may weaken.
This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity. Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.