Summary: Commodity price volatility due to currency swings will have a tremendous impact on companies that source their goods globally.
Key take-out: Australian activist investors should be demanding businesses mobilise now to upgrade their corporate governance around commodity risk management.
Key beneficiaries: General investors. Category: Investment strategy.
The currency wars have already started – and commodity based businesses are in the thick of it, despite iron ore and coal enjoying an uptick since mid-2016.
And the currency wars may prove challenging for individual investors. One could argue that it will be difficult to fairly value businesses exposed to these currency swings. Aggressive investors should consider searching for the emerging leaders – businesses that are proactively shaping their responses and that are making public statements. All investors though should expect wilder and more variable shareholder returns and valuations.
The last two years have crushed the markets’ belief in the predictability and stability of currency values.
In fact, Australia may be enjoying the calm before the next currency conflict breaks out.
Declining commodity prices have made many manufacturing businesses look good and led economists and analysts to debate whether we are at the end of a commodity super cycle that will propel prices even lower.
Chart 1: Australian manufacturing has outperformed since commodity prices started their decline in 2014.
Source: Bloomberg, Eureka Report
For example, as China tries for a 'soft landing' of decelerated economic growth, commodity prices could fall further as demand slows. If so, those lower prices may be giving business leaders a false sense of peace.
Globally, the decline in commodity prices is already adding political pressure on commodity exporters such as Australia and Saudi Arabia to do something, and is sparking political unrest in countries around the world such as Russia and Venezuela.
It leads one to expect that currency wars have started when we consider the following:
• 'Francogeddon'. In January last year, Switzerland abandoned its peg to the euro and threw financial markets into chaos, with the value of the Swiss franc spiking to more than 20 per cent above its prior valuation relative to the US dollar.
• 'Brexit'. Mainstream media missed the anti-EU sentiment building in the UK, causing many to be startled when voters there supported the Brexit effort to leave the European Union in June this year. The economic impact was immediate and by mid-October the UK pound had fallen 18 per cent against the US dollar.
• Struggles of 'Abenomics'. After some success, Shinzo Abe’s economic policies of fiscal stimulus and monetary easing for Japan are struggling to contain the value of the yen, which has risen 14 per cent since the beginning of 2016.
• Chinese moves. In August 2015, China changed the structure of how exchange rates are fixed, enabling more market input on its valuation. This sent the currency on a steady downward slope. The yuan is now down 8 per cent in US dollar terms as compared to January 2015.
What this means is that investors today are operating in a world where both commodity and currency values are changing rapidly – and in unpredictable ways.
Rising commodity-price volatility
As investors in Australia adapt to this new reality, currency volatility is likely to trigger commodity price volatility.
This will have a tremendous impact on companies that source their goods globally – and will especially impact local businesses, which are so reliant on commodity exports.
That is because the structure of commodity production is not set up to withstand these swings in currency prices. Domestic production cannot be started quickly enough to replace supply disrupted by the increased costs of imports. Increased costs often have to be absorbed by the consumer.
The current unstable economic outlook should compel company directors to take action now before it’s too late. Yet given what we have experienced in commodity prices over the past few years, many organisations overlook how important commodity volatility is to their overall enterprise risk. For that reason, any uptick in commodity volatility would catch many companies off guard – and the impact for investors could be significant.
Investors should demand that action become a "C-suite" (chief executive officer, chief operating officer and chief information officer) priority. While many organisations are not ready to manage commodities in a comprehensive, end-to-end manner, there are actions a company can take now in preparation for higher prices.
Things investors should be calling on the C-Suite to do
1. Define and publish a commodity risk management strategy (CRM) throughout the business. Many organisations have different perspectives on what the risk strategy should be. Should the company try to outperform the market? Can market intelligence be used to gain an advantage? Would it be better to pay a premium for stability? How far in advance should the company plan in these uncertain times?
2. Agree how CRM will be measured. What are the objectives of the risk management program? How will performance be measured against these objectives? What metrics are needed to track this?
3. Arm the business with a full arsenal of CRM weapons. Effective CRM is not simply derivatives and other financial hedging strategies. Leaders should consider a full spectrum of solutions, including partnering with suppliers to manage risk, integrating CRM into pricing actions and, where possible, changing the long and short physical stock holding positions.
4. Execute CRM as a standard business-as-usual process, not as an exception driven by market disruption. Strong CRM systems have a tiered governance structure to balance executive involvement, decision-making and escalation protocols for extreme market disruption. The process is well structured and not reactive, and is transparent to stakeholders with roles and responsibilities defined. The process is supported by a set of standard tools that reside in a central repository.
5. Upgrade internal tracking of currency and commodity markets and develop a single voice on the market data. The different functions of the business (marketing, supply management, supply chain, finance) need the same feed of information to make decisions. While opinions will vary on the future, the business should be fully informed and aligned on the past and present.
Activist investors should be demanding businesses mobilise now to upgrade their corporate governance around commodity risk management and commodity buying strategies. This may be the end of the calm before the next commodity storm begins.
John Piatek is a principal at international management consulting firm A.T. Kearney, based in Chicago, USA.