Goldman's Aussie short game

Going long on the S&P500 and short on the Australian dollar has been a crowded yet successful trade this year, and leading investment bank Goldman Sachs is adamant investors should stick with it.

The Wall Street institution this week started its countdown of the top 10 trades to pursue in 2014 by singling out further weakness in the Aussie dollar as a moneymaking opportunity in a year likely categorised by improvement in developed market economies.

“Given our forecasts for both assets, with an S&P year-end target of 1900, and a year-end Australian dollar target versus the US dollar of 0.85, we see scope for both legs of the trade to generate potential returns,” Goldman Sachs explains in a note to clients, which represent modest trading gains of 5 per cent and 7 per cent, respectively.

It appears a perfect storm is brewing, with the Australian economy stagnating and US interest rates rising. If both trends gather momentum then 85 cents may prove optimistic to the upside come December 31, 2014.

“Over the last year or so, the Australian dollar has also become increasingly negatively correlated with US rates, which is exactly the characteristic that we seek,” the investment bank advises.

“In addition, we think it is facing its own headwinds, and from a pure currency perspective, relative to most other G10 currencies and major emerging markets, it is a currency where we still expect reasonable declines.”

Given Goldman’s recent success in predicting Aussie dollar softness and its powerful presence in markets, the forecast should not be taken lightly.

The investment bank has been bearish on the local unit for over 12 months and last year declared one of the best trades on offer was ‘long the euro and short the Aussie’.

In fact, a Goldman employee suggested it represented the “trade of the century” in a Wall Street Journal article published in October 2012. While it may not have proven the trade of the century – the Aussie has lost 15 per cent against its eurozone equivalent since then – it has proven successful for those who had the capacity to follow the bank’s advice.

Goldman appears to be applying the mantra of ‘when you are onto a good thing stick to it’. As a prediction, however, it is relying on a few bricks falling into place.

For starters, Goldman expects the Reserve Bank of Australia to have one more rate cut left in its pocket, which is questionable. Economists are currently divided as to whether the next move is up or down.

On the one side, the mining sector is cutting back investment while the non-mining economy remains home to tepid growth, but on the other, we are already at record low rates, unemployment remains quite low and the housing market is starting to gather steam.

Given the contrasting views on the topic, a rate move in either direction would have significant implications for the dollar.

The investment bank is also basing its forecast on continued improvement in the US economy and commodity prices sinking. On the latter, it has issued something of a warning on commodities, with copper, iron ore and gold among those seen as ripe for falls of around 15 per cent.

While it expects an 85-cent number by the end of 2014, the bank has previously asserted 65 cents is possible in the medium term. And this is reliant on significant weakness in commodities of the like it anticipates next year.

For the Abbott government as well as Reserve Bank governor Glenn Stevens and trade-exposed industries, the Goldman currency call comes as music to the ears, with strong hopes the local unit can extend on losses of 12 per cent so far this year. They might, however, prefer a figure of 80 cents to give the economy some real stimulus.

Goldman’s long position on US equities is less assured than its Aussie dollar call, however, with the bank warning last week there’s a 67 per cent chance of a 10 per cent correction at some stage next year.

Still, it sees the stars aligning for an overall rise for the S&P500 of 5 per cent in 2014, which would add to recent years of strong growth.

The market gained 23 per cent in 2009 and 13 per cent in both 2010 and 2012, either side of a flat 2011. Add the 5 per cent forecast for 2014 to the 26 per cent this year and the S&P500 would be 180 per cent above the lows hit during the depths of the subprime crisis.

That’s quite a recovery. But, with valuations stretched on a historical basis, will we soon have to wait for economic growth to play catch-up?