Mining the dollar's devaluation

Most metal prices fell last week, while the metals and mining index on the ASX rocketed up by 9.4%. It was a near-perfect demonstration of the power of a lower Australian dollar on miners and oil producers exporting in US dollars.

There could be more to come as the tide turns against the Australian currency, which is being driven down by multiple factors. These include weakening terms of trade caused by lower commodity prices, and uncertainty over the federal government’s budget deficit and rising debts.

But it is also likely that the first flush of the currency effect on resource companies’ shares has delivered the best of the immediate price bounce, with future currency moves dependent on the pace and depth of the fall in the Australian dollar.

Companies that benefitted from the falling Australian dollar last week (and expectations that large resource stocks will start paying higher dividends and possibly benefit from the entry of private equity funds into the sector) included all of the major mineral and oil exporters such as BHP Billiton, Rio Tinto, Woodside, Santos, Fortescue, Newcrest, and Iluka.

Those stocks, along with smaller exporters such as Atlas Iron and BC Iron, will improve further if the Australian dollar continues to fall. This is an event on which there are divided opinions, but with the result more likely to be further significant steps down – an initial target being US95c and then perhaps below US90c.

As the currency slides, driven by speculative currency traders and official pressure in the form of the Reserve Bank’s interest rate settings, Australian resource stocks will perform strongly.

The challenge for investors is to recognise that what’s happening is almost entirely a currency event, perhaps the most unpredictable force in global markets, because underlying commodity prices remain weak.

BHP Billiton, for example, last week rose by $2.78 (8.7%) to $34.75 despite flat iron ore and oil prices. It was aided by a modest recovery in the copper price.

Rio Tinto, which is even more heavily dependent on iron ore than BHP Billiton, rose by $3.96 (7.3%) to $58.45.

Among the brokers, Rio Tinto is on the buy list of Citi, JP Morgan, Deutsche and UBS, with a consensus 12-month price target of $62. BHP Billiton is on the buy list of Macquarie and UBS, but on the “neutral” list of other brokers including JP Morgan, BA Merrill Lynch, Citi and Credit Suisse. BHP Billiton’s consensus 12-month price target is $40.

Those price moves by the two dominant Australian miners, together with a 50c (14.6%) rise by Fortescue Metals to $3.91, and a $1.54 (16.6%) rise by Iluka Resources to $10.80, sit interestingly when compared with the rest of the market, and underlying commodity prices as reported in US dollars, which is the global currency for most commodities.

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The surge in the metals and mining index last week compared with the 1.68% rise in the All Ordinaries Index, but the move looks even better when measured against the 0.8% fall in the financials index.

Another way of measuring the currency effect was among gold stocks, where the underlying product is both a commodity and a currency.

On the ASX, the gold index rose by 8.1%, led by Newcrest, which added $1.38 (8.6%) over a week when the gold price fell by $US19 an ounce – but which rose on conversion to Australian dollars from $A1,448/oz to $A1,456/oz.

A commodity price comparison with index moves is where the currency effect comes through clearly, because while the share prices of Australian miners and oil producers were rising strongly it was not the same story on the metal and oil markets.

Copper, the bellwether of metals, had a solid week, rising by around 3% to $US3.35 a pound, roughly where it was a month ago. Nickel rose by 2% to $US7.01/lb, also where it was a month earlier, while the oil price was either flat (as measured by the West Texas Intermediate marker) or down $US1.50 (when measured by the Brent crude oil marker), and iron ore was steady at around $US130 a tonne.

That means trying to pick winners in the mining and oil sectors based on currency changes is largely a pointless exercise, because the force at work (currency) is a universal positive for all companies selling their goods and services in US dollars.

The same currency effect flows across into other export industries, with stocks such as CSL, Amcor, Boral and Coca-Cola Amatil expected to win when their US dollar sales are converted to Australian dollars.

In this situation it’s a case of buy the trend, and the trend for all exporters is up. Even if you missed the first big move last week there could be other sharp upward jolts together with a longer-lasting rise as funds are rotated out of banks into miners.

The source of a potential jolt is the trading activity of international funds and rich private investors.

Renowned currency speculator, George Soros, reportedly made a $60 million profit by short selling the dollar as it slid from around $US1.05 to $1 (and briefly below parity in intra-day trading last week) over just four weeks.

Soros, the man who made a profit of $US1.8 billion shorting the British pound in 1992 in a deal which is said to have broken the Bank of England, was joined last week by his protégé, Stanley Druckenmiller, who said investors should join the game by shorting the Australian dollar.

Speaking at an investment conference in New York, Druckenmiller was reported by the Wall Street Journal as saying that investors should avoid currencies of commodity-linked countries.

“We think the Australian dollar will come down, and will come down hard,” the multi-billionaire Druckenmiller said.

Currency movements are normally glacial, which is one reason why that US5c drop in the value of the Australian dollar over just 19 trading days is significant, in that it highlights the sudden decline of support for the dollar.

Another reason is that most seasoned observers expect the downward trend to continue. The big investment bank, Goldman Sachs, is forecasting an exchange rate of US97c by next year, and then down to US86c in 2016 and US83c in 2017.

Other currency watchers broadly agree. HSBC Bank Australia, in a currency commentary published today, reckons the dollar is heading for US95c by the end of the year, but will remain around that level next year.

However, if Goldman is right, and the Australian dollar keeps falling with US83c a target for 2017, and then down to its long-term trend value of US74c, there will be a major regenerative effect on the entire resources sector.

One of the challenges to playing the currency factor when making investment decisions is that the world appears to be engaged in a currency game of “race to the bottom”, as other countries seek to aid their exporters through currency devaluation. Japan is the most vigorous current player.

For investors who might have taken their eyes off the resources sector because commodity prices have been driven lower by the global economic slowdown, especially in China (Australia’s major customer for commodity exports), now is a good time to refocus because the currency effect could signal the start of a long-term revival.