Winners from a dollar demotion

PORTFOLIO POINT: The Australian dollar is being kept above $US parity by forces largely beyond our control. But as those support pillars are removed, our market should rally.

Gravity is a primal force. You can only deny its existence for only so long. Sooner or later, it catches up.

And so it is with what used to be known as the “Little Aussie Battler”, which until recently has enjoyed huge international support as a proxy to China’s growth and as an attractive AAA-rated high-yielding currency.

With almost every major agency downgrading global growth next year, the investment phase of the mining boom past its peak, uncertain growth prospects in China and a Reserve Bank clearly looking to ease rates, we are witnessing the block-by-block removal of many of the foundation stones that underpinned the local currency’s recent stellar performance.

If not for the determined attempt by almost every major trading bloc, the United States, the Eurozone and Japan, to debase their currencies, the local dollar already would be under serious pressure.

With coal prices again in decline and concerns about iron ore, many currency traders have begun switching to Canadian and even Kiwi dollars to broaden their exposure.

While the shortage of AAA-rated currencies with any kind of positive yield is likely to maintain demand for the Australian dollar, that can’t last forever without the fundamental support that our buoyant terms of trade have delivered during the past few years,

At some stage, possibly next year, the currency should begin to slide – particularly as the investment phase of the mining boom starts to wane. And that could provide some good opportunities for equity investors.

It has been a constant source of consternation and concern among commentators that, while the Australian economy has been a world beater since the financial crisis, our stockmarket has trod water, stuck in a trading range between 4,000 and 5,000 since the final quarter of calendar 2009. It is way below its 2007 peak of 6,700.

Wall Street, by contrast, was threatening to break into record territory just a fortnight ago despite the spluttering nature of the American economy and its uneven recovery.

In both cases, the link is currency. The weak greenback has boosted corporate earnings and helped America claw back some of the industrial export capacity that it lost to China in the first decade of the new millennium.

The strength of the Australian dollar, by contrast, has nobbled earnings for exporters and for any firms repatriating foreign income to these shores. In the lead-up to the most recent full-year profit reporting season, a wave of earnings downgrades demonstrated the debilitating effect of the currency and its impact on share values.

Many of the companies, mostly industrial and service businesses, that have laboured under the regime of a parity-plus currency have survived through a combination of asset write-downs, cost cutting and efficiency improvements. This could place them in a good position to reap substantial benefits if the dollar falls.

While unique factors apply to each company, it is reasonable to assume that should the dollar decline next year, it would be prudent to consider a reweighting back to industrial and service companies that either are import competing, export oriented or that have substantial offshore earnings.

Amcor, for example, has 85% of its sales outside Australia. Cochlear derives 42% of its income from America and another 41% from Europe. CSL and Ansell are global firms reporting in Australian dollars.

The casualty list of those that have fallen victim to the Australian dollar is extensive and the Reserve Bank finally appears to be taking notice, given the negative implications for employment should commodity prices remain weak without any compensating fall in the currency.

Among the hardest hit have been BlueScope Steel, Treasury Wines, James Hardie, Computershare, OneSteel (now Arrium and subject to a takeover), Billabong, Orica, QBE, News Corp, CSR, PaperlinX and Goodman Fielder.

Between August and November 2008, the Australian dollar plunged from just below parity to just above US60c. Those were the days when foreign exchange markets did the heavy lifting for the Reserve Bank.

That rapid fall dramatically altered the global trading dynamics for many of our large corporations and paved the way for a substantial boost in equity prices from March until October 2009 when it became clear western capitalism would survive.

China’s rapid growth, and the currency wars that began in 2010, spurred the Australian dollar back to parity and beyond, which has kept our stockmarket in check ever since.

With the dollar now refusing to budge, despite the obvious turn on commodity markets, the pressure is on the Reserve Bank to take decisive action with the only real weapon it has at its disposal, interest rates.

And while many commentators last week claimed the higher-than-expected inflation numbers would cause the RBA to have concerns about another cut this year, the opposite is more likely. Most of the price rises were in non-tradeable goods and were caused, not by increased demand but by regulatory hikes in power prices. This is taking money out of the economy, potentially reducing demand, the last thing a central banker with unemployment on his mind would want.

Actually, rates aren’t the only instrument the RBA wields. In recent months it has been increasing its stock of foreign reserves. That means it has been selling Australian dollars. Not directly into the markets but by a more circuitous route, probably with other central banks.

In the past few months its foreign reserves have risen by $863 million. That compares with a monthly average rise of just $49 million in the second quarter. So clearly that tells you the RBA wants the currency to drop.

Lower interest rates, of course, will benefit equity markets through the double-whammy effect. The yield gap between equities and fixed interest becomes irresistible while lower rates theoretically boost spending and lower corporate costs, thereby boosting earnings.

Just how low should the dollar go? It is worth remembering that it is change that has the effect, rather than absolute levels. Most of the pain of the currency appreciation has now been borne. So even if the dollar remains steady, we are unlikely to see the disappointing earnings that have occurred in recent years.

Bear in mind too that, despite the cries that the resources boom is over, that is far from the case. Those mine expansions and new industries such as coal seam gas mean we will be exporting far greater volumes of natural resources than a decade ago. And commodity prices, while well off their 2010 highs, are still vast multiples above where they were at the turn of the century.

There was panic when iron ore plunged below US$100 a tonne in September. It is worth remembering that in 2001, it was hovering around $11 a tonne.