It is not fashionable to call the Australian dollar higher. The last time we did it – predicting the Aussie dollar would rise to $US1.50 as long as the boom in China continued, a barrage of online abuse ensued.
The alarm is entirely understandable. Although a high Aussie dollar might be a good thing for overseas travellers, it is an anathema to exporters and anybody depending on the flow of foreign capital for a living.
Indeed, a high currency slows the whole economy down.
Unfashionable as it is however to forecast a rising Aussie dollar – and bear in mind there is accord in financial markets that the currency is already far too high and bound to fall – not everybody keeps solidarity with the consensus view.
Asian markets specialist Kerry Series told BusinessDay the unit was headed far higher for longer – $US1.50 was entirely plausible, as was parity against the euro. (Note, the dollar rose to a fresh record of 82 euro cents plus at the end of trading last week.)
Series, the chief investment officer of Asian equities investor, 8 Investment Partners, who oversees $US330 million in funds, points to the correlation between Asian sharemarkets and the performance of the Aussie dollar.
“It is going significantly higher over the next two to three years,” said the funds manager, citing “super-easy” monetary policy in the US and Europe and the consequent demand for Australian resources by Asian companies.
The correlation between the index of Asian share markets (including China but not Japan) has been 0.7 to 0.8 which means that for every 1 per cent increase in Asian markets the Aussie dollar goes up 0.7 per cent or more, says Series.
This trend is over the long term. It is not a day-trading principle. And it cuts both ways. When Asian markets fall, so does the Aussie dollar. Lately, they have been rising.
The correlation is a 16-year relationship. So what happened in the mid-1990s to cause it?
Asian markets, says Series, had been growing for 25 years but now this growth had transcended into an economic size which had an effect on demand for resources, and the suppliers of resources, namely Australia.
Just as the Asian sharemarkets forecast the health of the Asian economies, so do the Asian economies drive demand for our resources. The strong terms of trade have been reflected in the strong Aussie dollar for a decade and, as long as this trend continues, so should the strong currency.
Last week’s trade data, even stronger than anticipated thanks to mining exports, only serves to reinforce this point.
Drilling down to the prospects for Asian share markets then Series points to a “price-to-book” value of 1.7 times. That compares to a world market price-to-book of 2 times and an historical average on Asian markets of between 1 and 3 times over the past 35 years.
Return on equity (ROE) is a better measure of profitability, says Series.
The ROE of Asian markets is 14 per cent, right on its long-term average and reflecting a price-to-earnings ratio of 12 times.
Racked up against a mature market like Australia, 12 times does not look cheap but when it comes to Asian shares it is akin to buying a growth stock on a value-stock multiple. The outlook for economic growth is twice that of developed economies.
Even though forecasts for China have been pulled back recently, this “slowing” Chinese economy is still tipped to grow at 7 per cent.
The macro picture provides further support for the high Aussie dollar view. Australian government debt is low whereas sovereign debt in the US and Europe has brought financial markets to the brink of collapse.
Australia, as an investment destination, has rarely been so attractive – all predicated of course on Asian growth persisting. A fixed-interest investor for instance gets a negligible yield to park money in other developed nations.
The official cash rate, at 4.25 per cent, is a multiple of the US (Federal Funds rate 0.13 per cent), Euro repo rate 1 per cent, Japan’s target rate at 0.05 per cent, and the UK official bank rate at 0.5 per cent.
Even if, or perhaps when, the Reserve Bank cuts rates tomorrow, the prospective rate of 4 per cent will still be at least four times the rate of its mature-market counterparts.
Kerry Series argues that not only has Australia kept its status as a “risk-on” trade – whose assets perform well when things are good – but it is increasingly a “safe haven” as well.
This is borne out indeed by the ructions in Europe and the fact that, rather than tumbling back towards 80 US cents as predicted by most pundits the Aussie dollar has bolted back up to $US1.07 and now toys with records against the euro at 122.
It is fair to say, though, that any shock in Asia, a crash in the Chinese economy for instance, would have devastating effects on Australia.
Series is not contemplating this. The prospects for Asian markets over the next two to three years are very bright he argues.
He puts down the tight consensus on a falling Aussie dollar to behavioural finance and the “anchoring” of economists’ forecasts to acceptable ranges. What was once considered too high, that is parity with the greenback is now considered acceptable. “Previously 70 US cents was the level. They keep moving it up to the ‘right level’,” says the funds manager.
“I have sympathy for the view that the Aussie dollar at these levels is expensive and painful but I expect that it will remain high for longer”.
The stimulatory policies of the US and Europe, by keeping their rates so low, will also stimulate Asian markets and consequently their demand for our resources, he says. Besides the US zero rate commitment for the next two years, the ECB is committed to unlimited funding for the banks. “It’s super-easy monetary policy”.
Bear in mind that, since the financial crisis in 2008, both Europe and the US have expanded their balance sheets by more than $2 trillion each – that is a lot of extra greenbacks and euro swilling about the global system.
Australian dollars on issue, meanwhile, have remained roughly the same.
Nevertheless, most foreign exchange assumptions in financial markets have the Aussie dollar at parity or below. The focus on the currency will intensify as we move into profit reporting season in coming weeks. Those companies such as Billabong, QBE, James Hardie, Bluescope, CSL, Cochlear and Resmed (all highly USD-sensitive) and Amcor, Brambles and Orica (US and Euro) will feel the pain.
For the likes of Qantas and Boral there will be little impact as their revenues are largely local.
Credit Suisse in a note to clients this morning said there was potential for currency to have a “negative impact on several companies”.
“In particular, we note the movement of the AUDEUR, which has appreciated by approximately 10 per cent over the past quarter,” said the broker.
“Both the AUDUSD an AUDEUR cross rates have experienced volatility over the period, which, when coupled with the volatile nature of the economic recovery in these regions has the potential to impact upon the clarity of underlying earnings growth.
The direction of the Aussie dollar, said Credit Suisse, was dependent on the extent to which global growth and deleveraging risks played out.
“Our base case, which incorporates the risk of no releveraging in the US resulting in downside risk to earnings, further deleveraging in Europe impacting economic growth across the region, and further mild property price decline in China at a time of when funding conditions are tight, sees downside risk”.
Overall, the broker said that there was “scope for significant earnings disappointment going into the reporting season as a result of the weak economic growth we have seen over the past six months, and downside to the outlook for FY12 and FY13 as a result of the risks to economic growth that remain.
“As such, the 1H FY12 reporting season may prove to be a period in which consensus EPS growth expectations are downgraded.”
Contrary to the view of Aussie dollar bull Kerry Series, Credit Suisse believes that emerging markets would lead a slowdown, “with yield curves most inverted in China and India. Developed market yield curves are not yet inverted – but this may be down to the deflation risks.
“The exchange rate is overvalued,” said the research, “reducing manufacturing export competitiveness and offshore profits. On our estimation, the exchange rate is expensive relative to commodity prices and interest rate differentials.
Out of whack
Evans & Partners chief investments officer Mike Hawkins, meanwhile, points out that Australia’s inflation has been outpacing peers – and the nation’s productivity is lagging – for more than a decade which has created the mispricing evident in the OECD.
On a comparative buying power ranking, only Norway and Switzerland lagged Australia. A typical basket of goods would cost a third of Australia’s in Turkey, the cheapest nation in the OECD survey.
Yes, “financial market dynamics” are driving the Australian dollar and may continue to do so, but the dollar’s strength is in direct conflict with economic theory and reality – as the constant hollowing-out of Australia’s industry base highlights.
The higher the dollar goes, the greater the damage to about 85 per cent of the economy (service sector outsourcing is ramping up – combination of relative unit labour costs, relative education levels and the step up in technology).
At $US1.50, Australia would be a land of miners (digging up iron ore, coal and gas which is going to be swamped with new global supply over coming years) and public servants.
This columnist suspects we are on this path already. We are being completely screwed by the world for our relative better management/better luck through the global financial crisis – the recovery is coming at our expense.
There will inevitably come a point where this reality compromises the macro bottom-line for Australia (already evident in case of jobs, underperformance of Aust equities) and the economy suffers. The “financial market dynamics” will then turn against Aussie dollar.