Recalibrating into the dollar's downturn

If you believe the rhetoric, the Aussie dollar is wedged into a steady traffic flow on a south-bound highway with no chance of an exit.

In the space of a few weeks it has dropped from well above parity to the mid-90s, with a raft of global hedge funds desperate for it to continue its plunge and cash out their potentially lucrative short positions.

Until yesterday, however, despite their best efforts, the currency slammed on the brakes at US95 cents.

As the rush from global investors to liquidate positions in Australian equities gathered pace, the local currency edged below that crucial level, dropping as low as US94.78c.

It is worth remembering, however, that it went even lower less than two years ago, in October 2011, when it plumbed US93.88c.

Longer term, the fundamentals are in place for the domestic currency to ease back to US90c, and possibly even lower. A shift of that magnitude will require a reorientation of investment portfolios, towards US assets, either through domestic operations with exposure to US dollars or American-based entities.

But don’t expect the currency shift to be immediate or linear. In fact, there is every chance the Aussie battler will recover ground against the greenback in coming months, giving investors enough time to adjust before it begins its final descent.

As with any abrupt market move, it generally is overdone in the initial phase. As dramatic as the Aussie fall has been, until yesterday morning, it was still within its 12-month trading range.

But the currency selling of the past fortnight, which is now spilling into equities, has been overdone, for the short term at least. Similarly, there are good reasons to believe the sudden demand for greenbacks has been premature.

Tectonic forces

Two tectonic forces have combined to weigh on the Aussie. The first is that it is now clear that we have reached the summit of the mining investment boom. And the second is that America is in the early stages of recovery that inevitably will see the Federal Reserve wind back its stimulus and allow the greenback to strengthen.

The catalyst for the currency drop in the past month was some oblique comments from Federal Reserve supremo Ben Bernanke, hinting at an eventual winding down of QE III.

Was that such a revelation? Not at all.  

It was, in fact, a brilliant bit of market massaging from the Fed chief, the first round of a softening up process that will see an orderly and gradual transition away from stimulus that, in turn, will allow for an easy adjustment to global capital flows. Bernanke wants to eliminate, or at least diminish, the potential for future shocks.

What was missing from his pronouncement was any hint at timing. And there are a couple of factors that have been forgotten in the euphoria and panic of trading in the past few weeks.

The first is that the US cannot afford for the greenback to rapidly appreciate just now. That would undermine America’s global competitive position and harm corporate earnings at a time when Japan and Europe both are desperately trying to depress their currencies.

The second is that Bernanke has added an extra set of hurdles that must be overcome before he contemplates weaning the country off its economic amphetamine program. On top of the usual goals like GDP growth and inflation, the Fed now is committed to reducing unemployment to 6.5%.

On that score, the trend certainly is his friend. In April, US unemployment settled back to 7.5%, well down from the 8.1% jobless rate of a year earlier and the 10% peak of October 2009.

But the rate of decline – assuming it continues at that pace with Washington’s budget cutbacks – indicates that Bernanke is likely to continue his $US85 billion a month money printing extravaganza for at least the remainder of this year.

Strong fundamentals

On this side of the Pacific, there are still a number of strong fundamentals that will continue to put a floor under the Aussie even as the mining investment boom winds down. Record lows they may be, but our interest rates are among the highest in the developed world.

Then there is the not so trifling matter of Australia’s ‘AAA’ credit rating, a rarity among developed nations these days. Sovereign investors, municipal funds and some private investors often are mandated to purchase only such securities.

And while the economic growth statistics this week were weaker than expected, there were encouraging signs there too, most notably around exports and productivity.

It is worth remembering too that all those billions of investment dollars that have flowed into the economy in recent years – and which are still arriving by the boatload – will soon begin to generate a return, mostly in the form of export earnings, which again will place a floor under the Aussie.

The other unsettling factor on our dollar in the past month has been the rapid decline in iron ore prices to around $US113 a tonne. Judging by last year’s events, that may merely be seasonal as Chinese mills continue to pump out steel while running down their iron ore stocks. At some stage, either they have to stop producing steel or replenish iron ore stocks. The latter is more likely.

Investment strategies

There is no doubt the Aussie is in decline. That will require a recalibration of investment strategies.

A weaker currency should fuel a much-needed and long-awaited lift in domestic corporate earnings across the market.  Exporters will benefit from the increased competitiveness and stronger earnings that a weaker currency provides, while domestic operations will find themselves under less attack from imports.

Until a fortnight ago, many of those benefits already were priced into our stocks. But the heavy selling that has been led by foreign investors could now put many stocks back into buy territory. And once the currency settles, foreign buyers will return.

Deutsche Bank has estimated that at US95c, Australian corporate earnings would lift 5% in 2014 and at US90c, would rise by 9%.

Much of that improvement would be concentrated in resources earnings, the analysts found, with earnings rising between 12% and 22% with industrials rising 3 to 5%.

With the US economy showing signs of life, however, the potential for Wall Street to push towards further records will strengthen. Part of Bernanke’s recent jawboning was an attempt to curtail  financial markets’ stimulus dependency.

For four years, we have witnessed the perverse spectacle of markets reacting positively to bad news, in the secure knowledge Bernanke will have to keep those printing presses operating at full steam.

A rejuvenated American economy, a stronger greenback and a resurgent property market all bode well for the world’s biggest economy, which would feed through to Australia and the rest of the world.

US housing prices rocketed 10% in March. (To read more on Australian investment in US housing, click here). Clearly, rises in future will begin to moderate, but an exposure to a rising greenback and a recovering housing sector – through American REITs – would be an obvious long-term investment strategy for Australian investors.