Dollar’s sharp fall doesn’t add up

Forecasting foreign exchange moves is “a mug’s game” and while it makes interesting press, investors can’t and shouldn’t really take point forecasts too seriously.

With that in mind, there is a serious problem for retail investors at the moment. Banks, and especially some of the large global investment banks, are falling over themselves to downgrade Australian dollar forecasts. Plenty of people are now talking a fair value for the Aussie dollar is around US85 cents.

So what are investors to make of that? Well, I think we need to be very careful. Remember the key trick for investors is to make the distinction between the perceived risks versus the real risks. The market discourse, and many commentators and analysts, have a habit of getting overly excited about price moves in either direction, and in some cases analysts seem to be on autopilot – continually forecasting weakness and a declining $A.

Goldman Sach’s, for instance, received a lot of press this week for its forecast that the Aussie dollar would be at US85 cents over the next 12 months. The thing is, in late 2011, the last time the Aussie had a rout down around these levels, Goldman was similarly bearish on the currency, forecasting an $A around US95 cents for early 2012.  Instead, we saw the $A at $US1.05 for most of the first half of 2012, hitting a peak over $US1.07. By the by, Goldman also forecast Australian economic growth a little over 1% for that year – it ended up well above that at 2.5%. Then again, in 2012, it suggested Australia had a non-mining recession and forecast below-trend growth for Australia overall. Instead,  economic growth was well above. Indeed, economic growth in 2012 ended up being one of the best years we’ve had over the last decade – not that many people know this.  What this highlights to investors is that it’s not necessarily the loudest and most heavily publicised forecasts that are the most correct – and indeed it’s usually the opposite.

For mine, and noting that I am indeed bearish on the currency over the medium term, I’m not convinced by this latest sell-off. I don’t think it has any substance, for a number of reasons.

1. Firstly the speed at which the $A has slumped. The unit has lost 10% of its value over the last couple of months, which is the biggest drop since the market panic of early 2012. In addition to that, there have been four other instances over the last couple of years where the $A has fallen by roughly 10% or so (see chart 1).

Click to enlarge

2. Then consider that the $A is still receiving tremendous support, none of which has changed materially. So we have:

• The carry trade, where investors who can borrow at close to 0% in the US, Europe, UK and Japan and invest in higher-yielding currencies like the $A.
• High commodity prices – the terms of trade is down 15% from its peak but is still some 50% above its long-term average.
• A current account deficit that is around half the historical average at 2.2%.
• Some of the best public finances in the developed world, and one of the smallest public debt burdens.
• Australia has, and is continuing to record, stronger economic growth.

More to the point the whole conversation about whether the US Federal Reserve will taper quantitative easing or not is a bit of red herring. It doesn’t change the fact that Fed will still be printing money and that the $A still has a sizeable yield advantage. Indeed, if the current narrative is the correct one (that is, the Fed intends to taper QE soon and the Reserve Bank of Australia will continue to cut), then Australian bonds are probably among the most attractive in the world. There is already a significant yield advantage to Aussie debt, and with the RBA easing into a possible Fed QE tapering, then this makes a long position on Aussie bonds/short US Treasuries a no brainer (when the RBA cuts, bond prices generally rise). This will also act to support the Aussie dollar.

Against that backdrop, all the talk of an $A with fair value at US85 cents, or what have you, makes no sense at this stage. In addition to the above, think about the economic backdrop that led to the currency sinking so much on previous occasions. Risk aversion was extreme. The simple fact is the $A is a risk currency. It is a global growth play, and pretty much every major dip the currency has had has been due to global fears, safe haven flows into the $US and out of risk assets. Thing is, the globe is looking a lot better these days – no ‘Grexit’ (Greek exit), no US double dips etc.

This is more just a sentiment shift, and if there is anything we’ve learned over these past few years it’s that sentiment can snap back rapidly.

On the flipside I’m not seeing much bearish support outside of a lot of talk and some dubious forecasts. For investors, that can never be grounds for an investment decision.  Talk can only go so far and for me to be certain that my bearish medium-term Aussie dollar call is starting to unfold, I’d need to see some real action on some of the fundamental supports noted above – not forecasts, but real results.

Investment implications

I know there are plenty of folks, and some of the investment banks talking about all the opportunities the weak currency is going to provide investors – a boost to earnings etc, especially that of our miners. Personally I wouldn’t bet the house on that, and indeed I wouldn’t be making any portfolio changes based on recent currency moves at this point. Give it time to see where the dust settles.

As I’ve mentioned before, if the Aussie stays weak now, it’s because the mining boom is over – the global economy and particularly China are slowing. In that environment, the earnings of miners will tumble, regardless of what the currency does.

Global equity investors will likely steer clear of Aussie stocks. I mean think about it. You’re global investor, you see the AUD bouncing around, they see Goldman Sachs and professor Garnaut running around talking about a recession. Well they’re hardly going to buy Aussie stocks are they.

At the moment the main take out from recent currency moves is that global currency markets are proving to be extremely volatile and unfortunately.  Recall at the beginning of the year, in my piece The risks that matter in 2013, I nominated monetary policy, especially US monetary policy, as the key risk facing global markets at the moment.  You can see why now, given recent volatility. The unfortunate thing is all this volatility points to an ongoing underperformance for Australian stocks.

With that in mind, recent $A volatility means that investors should keep an overweight position in global stocks.  Recall that a key theme I’ve been running with since mid-last year is that investors should be diversifying abroad – at the very least to help protect your wealth from volatile currency moves like we’ve already seen.

Noting that, I certainly wouldn’t be selling out of European or US stocks just yet. If I’m wrong on the $A, then it’s going to sell some more and there will be a better place to take your profits, or conversely hold onto foreign currency denominated high-yielding stocks. If I’m right, and the unit bounces back some, I would use that opportunity to get into or top-up on your global portfolio.