Prepare for an $A bounce

The dollar has fallen … but don’t think it’s down and out.

Summary: The sharp fall in the Australian dollar over the last month has taken many by surprise, but the reasons behind the fall are clear. Likewise, there are clear reasons why the dollar should rebound over the near term, and why it could even break through parity again by the end of the year.
Key take-out: The waning of bearish factors, and an ongoing Asian driven resources boom, particularly from China, should help propel the dollar by year end.
Key beneficiaries: General investors. Category: Currency.

The Australian dollar has been falling sharply for some time, and apart from the fact that no market ever keeps going in the one direction for too long, there are also sound fundamental reasons to be an aggressive buyer at these levels.

From a tourism or export perspective we may not like the idea of an Australian dollar above parity to the US dollar, but it is still something we need to learn to live with, and work with. Certainly if the Australian dollar was too high near $US1.05, even $US1.10 at one stage, it also must now be seen to be reasonably cheap near US93/95 cents.

No doubt all those exporters and manufacturers, who were complaining so loudly above parity, are shrewd enough to have been buying this week. The recent fast fall in the value of the currency has been a gift for our exporters. As is often the case, however, many will be getting greedy and rubbing their hands with glee at the prospect of the currency falling even further. Some of the major banks latest forecasts are suggesting US80 cents, even US70 cents.

It might be worthwhile, at this point, to consider why the Australian dollar went so high in the first place. If similar forces are still at play, might it do so again?

The tremendous momentum behind the currency’s recent decline has been a function of both desire and reason. The desire for a lower currency has been widespread for some time. The dollar, after all, had become the cause of all our woes, and the obvious target to which to allocate blame. We seem to live in a “blame” society these days, and blaming the currency, which is incapable of defending itself, has been an easy recourse for those who were failing in their own particular way.

The Treasurer even blamed the Australian dollar for low revenue, while manufacturers blamed the dollar for their uncompetitiveness, and exporters blamed the dollar for reduced profits. How convenient?

Currency movements always pose challenges, as well as opportunity. Even an unfavourable trend can have a silver lining by way of competitive industry advantage. The Australian exporters, for instance who hedged many years ahead, as some of us were suggesting, from as low as US76 cents, have gained a clear and decisive advantage over their same industry competitors within Australia and often overseas too.

The point is, currency exposure is something that needs to be managed, just like legal and marketing risks do. This is well worth noting because right now Australian exporters have an opportunity to hedge their currency exposures some 10% below even recent highs. Boards of directors who do not take advantage of this opportunity, should be taken to task in the months and years ahead if, as could well be the case, the currency again heads upwards.

So what is the likelihood of the dollar beginning to strengthen again? There have been four major factors behind the “incredible shrinking dollar”. If these are valid, then the dollar will stay low. If not, then the dollar could well be due for a very surprising, to the many, major fresh rally!

Reasons for the shrinking dollar

1. Hedge fund speculative attack that no one spoke up against.

The country simply acquiesced as hedge funds took control. Of course, when everyone has sold what they want to, as in shorted any market, what those speculators tend not to realise is that they have now become nothing but a “sea of potential buyers”!

2. China is slowing and it is the end of the resources boom.

This is perhaps the hardest point of view of all to accept. The Chinese economy is around double the size it was a decade ago, which means 7.7% GDP growth now is equal in absolute resource demand terms, to about 15% growth back then. In other words, resource demand out of China is likely to be increasing at a faster absolute pace than at any time in its history, even with just 6% or 7% growth rates. Growth in the coming year is more likely to range between 7.5% and 8.5%. China is demanding and importing more resources every month. The resources boom never ended, and is likely to go for another 15-30 years, as the nation’s urbanisation process now shifts towards middle China, as well as continuing on the eastern seaboard.

3. Sharp domestic slowdown.

The significant slowdown in the Australian domestic economy was discussed here last week, and it is indeed a real phenomenon, one warranting significant policy response. While some forecasters had warned of this development for many years, for others this news has come as a bit of a shock. There has certainly been some significant further selling of the Australian dollar as a result of our domestic economic data releases of late. There are two points to consider here, however.

Firstly, is the poor domestic economic situation close to or indeed now fully priced, such that further poor data is unlikely to surprise markets? And secondly, whether in fact this trend will continue or there is a change of pace for the better on the horizon. Regardless of political leanings, I think it is fair to say that Australian businesses have been cautious about expansion or fresh investment this year as they await the outcome of the federal election. The policy stakes are high, and therefore create perhaps more than the usual degree of uncertainty.

The retention of investment potential is a major factor in the current slowdown. What this means however, is that once the election is out of the way, there will be a catch-up rush of investment and hiring that is likely to propel the economy toward 4.5% GDP in 2014. At some point, even the currency market must begin to pre-emptively price this probability.

4. Political turmoil

Further to the above point, recent intense media coverage of, sometimes extraordinary, political developments have reinforced broad community and certainly business thinking that to be cautious is the best policy for now. Occasional political flare-ups are part and parcel of any society, however, and these too will calm down with time. 

The Reserve Bank of Australia rate cuts are not given much weight at this point in the cycle here, as the process of official monetary policy reductions is now well accepted and very likely fully priced into the currency. The Australian dollar is in any case more about China than it is the RBA.

The major factors in the recent decline may still carry weight with many, but there are clearly vulnerabilities in the bears’ perspectives.

Perhaps the most important consideration of all, from a medium to long-term view of the currency, is that we are just an economy of 23 million people sitting on the world’s wealthiest pile of rocks, with 2 billion people just to the north of us who want those rocks. The degree to which Asia desires our mineral wealth is only going up, not down, and this suggests quite powerfully the direction of the dollar as well. This is the ultimate math with regard to our currency.

Perhaps one more slightly anecdotal point! When first forecasting the Australian dollar to rise to and above parity, in a media article in June 2006, with the dollar at US76 cents, all the banks said such notions were well, silly, as everyone knew the currency would never go above US80 cents again. The current situation, with all the major banks, global and local, lining up with their ever-more bearish forecasts, feels a lot like then.

It is indeed distinctly possible, with a waning of the bearish factors, and an ongoing Asian driven resources boom, that the Australian dollar will rise back above parity, to $US1.06 by year end, and perhaps even to $US1.13 this or next year.

Given this potential, it would be a little silly if our exporters were not already hedging?


Clifford Bennet is chief economist of the White Crane Group at http://www.whitecranegroup.com.au/eureka/

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