Aussie dollar parity – is it sustainable? Oliver

For the first time in 28 years the $A has spiked above parity against the $US, highlighting the culmination of a long hard slog back to form for the Australian economy.

In a longer term context it is the last 28 years below parity which is the aberration.

While the Australian dollar is vulnerable to a correction having risen so fast since late August, unless the global economy tanks again it is likely to average above parity over the next few years on the back of strong commodity prices and the relative strength of the Australian economy. Probably at around $US1.10.

While the high $A will make life tough for trade exposed companies without a natural hedge, on balance it is more of a positive for the Australian economy. It is unambiguously positive for consumers and will help limit the extent to which interest rates have to rise.

It’s taken a bit longer than I first thought1 but the Australian dollar has finally broken through to parity against the $US. This raises several questions – how did it get it here and is it sustainable? And what does it mean for the Australian economy and investors?

How did we get here?

The move through parity reflects a range of factors including downwards pressure in the value of the currencies of the major advanced countries led by the $US, strong commodity prices, a widening interest rate differential and strong economic fundamentals.

The global financial crisis has exposed a fundamental imbalance in the global economy and that is a high level of consumption and/or public debt in major advanced countries in contrast to low consumption and low debt in emerging countries. A necessary part of the adjustment to rebalance the world is that currencies in the G3 (the US, Japan and Europe) need to fall relative to those in the emerging world. This has been led by the $US and British pound but the Yen and euro will follow. The outcome is a bit like a race to the bottom in such currencies, with the $US leading the charge, receiving added impetus lately as the US moves towards another round of quantitative easing which will involve another boost to the supply of US dollars.

Against the background of a falling $US, the strength in the Australian dollar is being given added impetus by a combination of:

• rising commodity prices – they usually move inversely to the US dollar and their longer term trend higher is being driven by the commodity intensive demand in the emerging world. Commodities account for 70% of Australia’s exports and prices for virtually everything from coal to copper, from gold to wheat have soared over the last 18 months taking Australia’s terms of trade to its highest level since the 1950s;
• while the US and other major industrial countries are moving towards more monetary easing, the Reserve Bank of Australia looks set to raise interest rates and so further widen the differential in rates with the US and other major countries; and
• the global financial crisis (GFC) has improved investor perceptions of Australia. It is the only OECD country not to have succumbed to recession through the GFC; it has zero net public debt; and it is seen as well managed; and a relatively safe way to invest in the strong China story. This favourable shift in perceptions is likely adding to long term upwards pressure on the $A.

But is it sustainable?

Since the Australian dollar floated in 1983 the general perception was that fair value was around $US0.70 and most fair value models for the $A constructed over this period confirmed this (as would be expected). However, it’s likely this relatively narrow period of history misses the longer term perspective and the changed reality facing Australia. Back in 1901 the equivalent of one Australian dollar bought $US2.40 and for most of the last century the $A was above parity against the $US. The long term slide in the $A between 1901 and 2001 reflected a combination of soft commodity prices (which adversely impacted Australia’s terms of trade) and a perception of Australia as a mediocre, inflation prone “old” economy. 1950s when Australia’s terms of trade (the ratio of export prices to import prices) was around current high levels, the equivalent of one Australian dollar bought $US1.12.

In short, it is likely the sub-parity period from the 1980s was the aberration for the $A, and the improvement in Australia’s relative fundamentals suggest it is likely the $A is going to settle above parity against the $US.

Forecasting currency levels is an impossible task but I would suggest an average around $US1.10 is likely in the years ahead, unless the global economy collapses anew.

The impact of a rising $A on the economy and shares

The strong $A is great news for Australian consumers as it will result in lower prices for imported items. Imports account for nearly 30% of consumption goods, notably things like cars, clothing, petrol and many electrical goods.

This in turn is likely to take pressure off inflation and reduce the extent to which the RBA will raise interest rates.

For the broader economy and shares, a strong $A is often seen as bad news as export and import competing companies become less competitive. It’s much easier to identify companies that will lose from a rising $A via the impact on their earnings (such as resource stocks, multinational industrials, steel makers and various health care stocks) than to identify companies that benefit because of lower import costs (like some retailers and the airlines). With around 30% of listed company earnings sourced overseas, a 10% rise in the $A will mechanically cut earnings by about 3%. This would suggest a rising $A is bad the Australian share market.

However, the problem with this approach is that historically, the actual relationship between the $A and the Australian share market is ambiguous. In fact, in recent times a strong $A has gone hand in hand with economic strength, eg, over the 2003-07 period, and a weak $A has correlated with economic weakness, such as in the second half of 2008.

The reason is because while a rise in the $A is a dampener for company profits on its own, it’s normally associated with strong economic growth which is good for profits. This explains, eg, why the performance of resource shares correlates strongly with the $A, contrary to what an analysis of the $A’s impact on their earnings suggests. It’s also worth noting that periods of $A strength are normally positive for the relative performance of small caps because they are cyclical, have less offshore exposure and benefit more from lower import costs.

Given the latest bout of $A strength has been associated with renewed vigour in commodity prices, improved optimism regarding the global outlook and relatively stronger economic conditions locally, it’s unlikely to cause major problems for the share market or the economy at an aggregate level. This is because the direct negative impact on profit growth from the surge in the $A should be largely offset by the positive impact from solid economic conditions.

From a longer term perspective though, the rise in the $A will present challenges. It’s effectively helping to shift economic resources to the strongly growing resources sector of the economy, which is fine from a technical economic perspective but such restructuring will invariably have significant social and regional consequences.

The strong $A and investors

For investors, the rise in the value of the $A may not be good news as it will reduce the value of offshore investments, unless they are hedged. Global bond and property funds are usually hedged back to Australian dollars to remove the currency impact. However, global equity funds are usually unhedged, because the $A normally moves in line with share markets and so tends to smooth out their volatility. In 2008 the fall in the value of the

Australian dollar helped cushion the fall in international share markets for Australian based investors in unhedged international shares; but in 2009 the rise in the value of the $A completely offset the recovery in global share markets.

However, fully hedged international equity funds are available. With the $A likely to see further gains over time as the global recovery continues and G3 currencies continue to fall, there is a case to remain biased towards hedged international equity funds as opposed to unhedged funds.

The breach of parity for the $A against the $US, symbolises the improvement in Australia’s fortunes over the last decade. With major advanced country currencies likely to remain depressed and commodity prices likely to remain high, above parity for the $A is likely to prove sustainable, albeit with the normal high degree of volatility that characterises exchange rate movements.

Dr Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors.