Foreign exchange markets are playing an ever increasing role in domestic equity markets, especially in this day and age where currencies are being artificially lowered to help boost sluggish economic recoveries. This is often referred to as a global currency war whereby the likes of the United States, Europe, Japan and China are all trying to keep their currencies depressed.
Australia currently finds itself in largely uncharted waters due to a persistently high exchange rate and historically low interest rates.
However, this is not through a lack of trying from the Reserve Bank of Australia. There was a period from April 2013 to January 2014 where the RBA succeeded in lowering the Australian dollar. The AUD/USD fell from highs of 1.05 to lows of just above the 0.86 level through a combination of rate cuts and bearish rhetoric.
Since the January 2014 lows it has stubbornly climbed back towards the mid 90c level, which has highlighted the fact it’s not a level playing field. The RBA is fighting a currency war with a slingshot compared to the arsenal the US, Europe, Japan and China have available to them.
Currently, the AUD/USD is around the 0.9350 level, which incidentally is about three cents above the average forecast for second quarter 2014.
Looking ahead, forecasting currency movements is an incredibly difficult, if not impossible task. There are so many moving parts that even if you correctly forecast the domestic factors, you can still be at the mercy of global forces.
We are seeing this at the moment, especially as the US dollar continues to remain under pressure despite the tapering currently underway.
Recent strength in the AUD/USD can be put down to a number of factors. These include US dollar weakness, a more neutral domestic interest rate outlook and demand for Australian dollars as international money buys into Australian equities.
Against expectations for the domestic currency to weaken considerably for the remainder of the year (average year end forecast is 0.88 cents) we examine what might happen if it were to continue to appreciate. This is likely to occur if we continue to see US dollar weakness and/or the RBA moves to more of a tightening bias. This scenario will obviously not be helpful for US dollar earners such as Amcor, Ansell, Brambles, CSL and James Hardie.
Higher US dollar denominated commodity prices will of course support the miners, with the small-caps having more operational leverage to rising prices.
While there will likely be market wide earnings downgrades for those companies with international businesses, in the longer-term a stronger currency may actually be good for Australia.
A strong currency will force domestic businesses to become more productive and move up the value chain. There has been a long history, around the world, of companies adapting to a stronger currency and becoming more efficient, instead of moaning about the additional headwinds and remaining inefficient.
Ben Potter is Retail Editor at Baillieu Holst Ltd