Preparing for weaker dollar a prudent course

THERE are people who have made fortunes from betting on the direction of the Australian dollar. Unfortunately I have never met them.

THERE are people who have made fortunes from betting on the direction of the Australian dollar. Unfortunately I have never met them.

This is hardly reassuring for a sharemarket investor given the pivotal role currencies play in influencing individual share prices. As we have seen in recent years, the strong Australian dollar has cruelled some local industries such as steel while providing a major fillip for a range of stocks, especially importers.

If we can't predict which way the currency is heading, we must plump for a reactive approach but prepare judiciously by running various scenarios.

Investors have seen first-hand what happens when the local dollar rises. A more interesting scenario is to prepare for a weaker local currency against the greenback. An Australian dollar closer to US90? would have a major impact on where investment dollars would flow on the sharemarket.

The Australian dollar would seem to have two major influences. In the short term, the disparity between interest rates in the United States and Australia has a powerful role to play. The US Federal Reserve's decision to keep official rates at a historical low 0.25 per cent for an extended period has been a major source of support for the Australian dollar. The effect has been strengthened by the Reserve Bank of Australia setting domestic rates at a healthy 4.25 per cent.

Possibly a stronger long-term determinant of the Australian dollar is commodity prices. To

the world, Australia is a commodity-based economy and for many investors owning the Australian dollar is a means of getting exposure to the burgeoning growth in China. The Australian dollar has been highly and directly correlated with the price of copper for many years. Therefore, a decline in commodity prices should see the currency depreciate while a jump in commodity prices would see strengthening in the currency.

In summary, a reduction in local interest rates and a downturn in commodity prices would be the recipe for the Australian dollar to take a leg down from its current lofty levels. It would be foolish to predict this is about to happen, but if, by chance, it does, we could expect the following reactions on the sharemarket.

The first major beneficiaries would be companies that earn a large portion of their income in the US. A rising greenback would mean every dollar earned in the US would be worth more in Australian dollars. Companies in this category come from various industries and include Aristocrat Leisure, PaperlinX, News Corp, ResMed, Sims Metal, Brambles, James Hardie, Cochlear, CSL and QBE Insurance. Some of these stocks have enjoyed nice runs in recent weeks as the Australian dollar has rolled off its peak.

Another group of companies that would be grateful for a weaker currency are those that compete in the Australian market against imports. A strong dollar means offshore companies are more cost competitive against the locals. The culprits that fit into this basket are domestic steel producers BlueScope Steel and OneSteel. BlueScope in particular has been pushed to the brink by the strong dollar and was forced to recapitalise its balance sheet at the end of last year. It is no surprise the company's earnings are also the most sensitive among Australia's top 300 companies to a change in the currency.

In theory, resource companies that export products such as bulk commodities, copper, zinc and nickel should also benefit from a weaker Australian dollar. It allows them to be lower-cost producers of these products and more competitive against other commodity-rich nations. However, as explained, a fall in the Australian dollar occurs in tandem with weaker commodity prices. This would exclude the mining companies as beneficiaries of a softer currency.

Possibly the companies with most to lose from a weaker Australian dollar would be our importers, and to a large extent these are the smaller companies. In simple terms, these importers would lose some of their purchasing power and the cost of doing business would jump. This would be unwelcome news for the suffering retail sectors that import a large share of their goods from China but price them in US dollars.

Many players in the sector have complained about the impact a strong Australian dollar has had on discounting of goods. In reality, the strength of the currency has been a lifeline in an extremely tough environment where consumers have curtailed spending habits and the internet has challenged the traditional model of shop fronts. The retail sector can only hope that if the currency takes a tumble it will be on the back of lower domestic interest rates, which would stimulate spending by the debt-laden general public.

No discussion about the currency's impact on the sharemarket would be complete without acknowledging the happenings of 2008.

The Australian dollar dived almost 40 per cent against the greenback in just three months. This was a nasty reaction to the collapse of Lehman Bros, and investors deserted all risk assets around the globe and ploughed into US dollars. This was an unusual event that has little to do with interest rate differentials or commodity prices. If this scenario was to happen again, don't bother about buying any shares. Stick your money under the mattress.

Former fund manager Matthew Kidman is director of WAM Capital.

The US Federal Reserve's decision to keep official rates at a historical low 0.25 per cent for an extended period has been a major source of support for the Australia dollar.

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