Key pointsWorld Peace

After doubling in value against the $US over the last decade, the best is likely behind for the Australian dollar.

The commodity price boom is starting to fade in response to a moderation in Chinese growth as commodity supply starts to increase, the impact of quantitative easing in the US is being blunted by rate cuts in Australia with the prospect of more to come and the rise in the $A has exposed the high cost base of the Australian economy.

While further gains are likely in the value of the $A against the Yen (to around ¥110 by year end), the $A is likely to remain range bound this year against the $US with the risks on the downside, particularly over the next few years.

For Australian based investors, this means less need to hedge global exposures back to Australian dollars.

Introduction

The last decade saw a huge surge in commodity prices on the back of rapid growth in demand, as China industrialised, and as the supply of commodities was constrained. This hugely benefitted assets geared to commodity prices including emerging market shares in South America, resources companies and of course the Australian dollar which were all star performers.

For the $A it meant a rise from a low in 2001 of $US0.48 to a high in 2011 of $US1.10 and a 70% gain on a trade weighted basis. However, since 2011 the outlook for the Australian dollar has become more confused: commodity prices are high but have been sliding recently; monetary easing (particularly money printing) in the US and Japan is positive for the $A but has been blunted slightly by rate cuts in Australia and the chance of more to come; safe haven flows from central banks looking to diversify have helped support the $A but I get the feeling that they are late to the party and some would question Australia’s safe haven status; and the damage to Australia’s international competitiveness has become more evident.

Purchasing power parity

One of most common ways to value a currency is to compare relative prices. According to purchasing power parity theory, exchange rates should equilibrate the price of a basket of goods and services across countries, such that 100 Australian dollars would buy the same basket of goods in other countries as it does in Australia when translated into their currencies. A rough guide to this is shown in the chart below which shows the $A/$US rate against where it would be if the rate had moved to equilibrate relative consumer price levels between the US and Australia over the last 110 years or so.


Source: RBA, ABS, AMP Capital

Quite clearly purchasing power parity doesn’t work for extended periods with huge divergences evident at various points in time when the $A was fixed such as in the 1950s and 1960s and/or when other factors come into play. In fact, the $A as has gone from being dramatically undervalued in 2001 to similarly overvalued now on this measure now. However, it does provide a guide to where exchange rates are headed over very long periods of time. Such an approach has been popularised over many years by The Economist magazine’s Big Mac index.

An obvious problem with such measures is that they can give different results depending on the estimation period and the types of prices used. The relative consumer price measures used in the chart above would suggest that the $A is currently around 35% overvalued, whereas according to the Big Mac index it is only about 12% overvalued.

However, the broad impression is that the $A is overvalued on a purchasing power parity basis. This is consistent with current perception and news stories recently appearing about how Australia has gone from being a relatively cheap country a decade ago when the $A was much lower to an expensive country today. This suggests the $A could face downward pressure if some of the factors that have been holding it up reverse.

The major factors on this front are commodity prices, relative monetary policies and perceptions of Australia as a safe haven.

Commodity price boom starts to fray

Over the last forty odd years swings in commodity prices have been perhaps the main driver of the big picture swings in the $A. Rising commodity prices helped the $A into the mid 1970s, falling commodities correlated with a fall in the $A until around 2000 and over the last decade rising commodity prices explained the huge surge in the $A. The logic behind this is simple. 70% or so of Australia’s exports are commodities and moves in commodity prices are key drivers of our export earnings. However, the commodity price story is starting to fray at the edges. The pattern for raw material prices over the past century or so has seen roughly a 10 year secular or long term upswing followed by a 10 to 20 year secular bear market, which can sometimes just be a move to the side.


Source: Global Financial Data, Bloomberg, AMP Capital

The upswing is normally driven by a surge in global demand for commodities after a period of mining underinvestment. The downswings come when the pace of demand slows but the supply of commodities picks up in lagged response to the price upswing. After a 12 year bull run since 2000 this pattern would suggest that the commodity price boom may be at or near its end. Specifically, growth in China remains strong but it has slowed a bit (from 10% plus growth to 7 to 8% growth) just at the time when the supply of commodities is about to surge after record levels of mining investment globally. And a basing in the $US is also not helping: the falling $US helped boost commodity prices from around 2002 as they tend to be priced in US dollars. Now with the $US looking a bit stronger this affect is fading.

The chart below shows an index of prices for industrial metals such as copper, zinc, lead, etc, against the $A and suggest that they have gone from a positive influence, leading on the way up last decade, to potentially a negative.

Source: Bloomberg, AMP Capital

Relative monetary policies

Quantitative easing in the US, Japan and elsewhere should be positive for the $A as it means an increase in the supply of US dollars, Yen, etc, relative to the supply of Australian dollars. And indeed it has been. Various rounds of QE in the US have been associated with $A strengthening, and the heightened efforts by Japan on this front only add to this pressure and have helped to push the $A up 25% over the last six months and the trade weighted value for the Australian dollar up to its highest since early 1985. Our assessment remains that as the value of the Yen continues to fall in response to aggressive monetary stimulus from the Bank of Japan, the $A will see further gains against the Yen, taking it to around ¥110 by year end.

However, against the $US the impact of quantitative easing may be starting to wain a bit. As can be seen in the chart below, while the first two rounds of quantitative easing in the US were associated with strong gains in the value of the Australian dollar, QE3 has just seen the $A continue to track sideways in the same $US1.02 to $US1.06 range it has been in since last July.

Source: Bloomberg, AMP Capital

This may be partly because QE3 has not seen a rise in commodity prices. But the main reason that the impact of quantitative easing may be starting to wain for the $A is that the interest rate differential in favour of Australia has fallen dramatically as the RBA has cut rates. With the Australian economy still struggling this may have further to go.

What about central bank buying and safe haven demand?

Buying by central banks looking to diversify their foreign exchange reserves and by investors allocating to a diminishing pool of safe AAA rated countries has no doubt played a role in boosting the $A. However, one can’t help but think that after a decade long bull market in the $A (or bear market in the $US) central banks are late to the $A party. And with the fading of the mining boom and the Government struggling to bring the budget back into surplus it has to be recognised that Australia is not without risk. So my feeling is that this source of support for the $A will start to fade.

Implications for investors

The bottom line is the best has likely been seen for the $A and the risks are on the downside over the years ahead as the commodity price boom fades, allowing the $A to correct some of its overvaluation on a purchasing power parity basis.

Currency is very important for investors as soon as they invest in foreign countries. Most global investments offered by fund managers come with a choice of being unhedged, ie exposed to fluctuations in the value of foreign currencies, or hedged, where the value of the investment is locked back into Australian dollars.

Over the last decade unhedged international shares returned 2.7% pa whereas hedged international shares gained 9.5% pa. The difference largely reflects the rise in the $A (+4.4% pa), but also the interest rate differential between Australia and the rest of the world (+2.4% pa). But if the $A is likely to go sideways or down there is much less need to hedge and with the interest rate gap between Australia and the rest of the world narrowing there is much less incentive to hedge.

In other words the reward versus risk equation in favour of the $A is diminishing so it makes more sense for investors now to consider taking an exposure to foreign currencies (ideally with the exception of the Yen) beyond the Australian dollar and obtaining the diversification benefits they provide.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

 

This material has been provided for general information purposes and must not be construed as investment advice. This material has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances prior to making any investment decisions and should read the relevant Product Disclosure Statement.

 

Published in Investment Advice
Monday, 08 October 2012 18:47

Where to for the Australian Dollar?

The strength of the Australian dollar has been positive for those wishing to travel overseas or to purchase goods online from overseas, but inbound tourist operators, exporters and bricks and mortar retailers are not likely to share the enthusiasm.

The Australian currency is often referred to as a commodity currency which means that it generally behaves in keeping with commodity prices.

Below is a chart showing the long term trends of Commodity Prices (green line) and the $AUD/$USD (blue line).

$AUD vs Commodity Prices

Source:  IRESS, RBA and Macquarie September 2012

In the past 20 years the Australian dollar has followed the Commodity Price Index, and yet right now there lies a massive gap between the currency and commodity price index.

Picking currency trends is a dangerous occupation, however it seems to be accepted within the finance profession that the Australian dollar is over valued and is only a matter of time before is corrects itself.

Should the Australian dollar devalue, which investments would benefit?

  • Unhedged International Equity Funds
  • Australian companies with earnings from overseas (providing not hedged), ie CSL
  • Companies providing in bound tourism services
  • Australian companies exporting goods (providing no hedging)

This material has been provided for general information purposes and must not be construed as investment advice. This material has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances prior to making any investment decisions and should read the relevant Product Disclosure Statement.

 

Published in Investment Advice

The miners are big enough to play dirty

Key points

  • The mining investment boom still has another year or two to go but its peak is starting to come into sight and the best has probably been seen in terms of commodity prices.
  • While there is the risk of a timing mismatch around the end of the investment boom in 2014 and as other sectors take over in driving Australian economic growth, the eventual end of the mining investment boom should lead to more balanced Australian growth.
  • The eventual slowing of the mining boom should mean lower interest and term deposit rates, the best is over for the Australian dollar (A$) and a more balanced share market.

Introduction

Recent weeks has seen much debate and consternation in Australia as to whether the mining boom that has supposedly propelled the economy for the last decade is over. This followed the cancellation or delay of various resource investment projects including the massive Olympic Dam expansion and a fall in commodity prices over the last year.
But is it really over? And would it really be the disaster for Australia that many fear? After all, we have had years of hearing about the two-speed economy where the less resource-rich south eastern states were being left behind and it was said that the people of western Sydney were paying the price (via higher-than-otherwise interest rates and job losses) for the boom in Western Australia, so many Australians might be forgiven for thinking good riddance.

Semantics and confusion

Much of the debate about whether the mining boom is over has been characterised by confusion as to what is being referred to with some focusing on commodity prices, others on mining investment projects and others saying that technically it hasn’t even begun until mining and energy exports pick up. In broad terms the mining boom that has gripped Australia for the last decade likely has three stages.

The first stage, or Mining Boom I (MB I), began last decade and saw surging resource commodity prices driven by industrialisation in China. This resulted in a rise in Australia’s terms of trade to near record levels (see the next chart). This phase was initially good for
Australia last decade as it seemingly benefited everyone. Resource companies got paid more for what they produced, their profits surged, they employed more people, and they paid more taxes, which led to budget surpluses and allowed annual tax cuts. They paid more dividends and their share prices went up. The A$ rose but not to levels that caused huge problems for the rest of the economy. So, not only did the resources companies benefit but there was a big trickle down effect to almost everyone else. As a result the economy performed very strongly and unemployment fell below 4%.

 

The second stage, or Mining Boom II (MB II), has been characterised by a surge in mining and energy investment. This has been underway for the last few years and will take mining investment from around 4% of gross domestic product (GDP) in 2010 up to around 9% in 2013, contributing around 2 percentage points to GDP growth in each of 2011-12 and 2012-13.

 

The third stage, or Mining Boom III (MB III), will presumably come when resource exports surge on the back of all the investment.  So where are we now? In terms of the commodity price surge that characterised MB I, it’s likely that we have either seen the peak or the best is over with more constrained gains ahead:

  • Firstly, the pattern for raw material prices over the past century or so has seen roughly a 10-year secular or long-term upswing followed by a 10- to 20-year secular bear market, which can sometimes just be a move to the side.

 

The upswing is normally driven by a surge in global demand for commodities after a period of mining underinvestment. The downswings come when the pace of demand slows but the supply of commodities picks up in lagged response to the price upswing. After a 12-year bull run since 2000 this pattern would suggest that the commodity price boom may be at or near its end.

  • Global growth appears to have entered a constrained patch. Excessive debt levels in the US, Europe and Japan have constrained growth, while potential growth in China, India and Brazil looks like being 1 or 2 percentage points lower than was the case before the global financial crisis. This means slower growth in commodity demand going forward.
  • The supply of raw materials is likely to surge in the decade ahead in response to increased investment.
  • Finally, the surge in commodity prices since 2000 was given a lift by a downtrend in the US dollar from 2002 as commodity prices are mostly priced in US dollars. This has now likely largely run its course.

Taken together, this would suggest that the best of the commodity price surge since 2000, or MB I, is behind us. There are two qualifi cations though. First, after the recent short-term cyclical slump there will still be a rebound, probably into next year as global growth picks up a bit. Second, it’s way too premature to say that the surge in demand in the emerging world is over - China and India are still very poor countries with per capita income of just US$8,400 and US$3,700 respectively compared to US$40,000 in Australia suggesting plenty of catch-up potential ahead and related commodity demand.

In terms of MB II, while the cancellation of Olympic Dam and other marginal projects indicates that projects under consideration have peaked, this does not mean the mining investment boom is over. In fact it probably has another one to two years to run. Based on active projects yet to be completed there is a pipeline of around A$270 billion of work yet to be completed. Iron ore related capital spending (on mines and infrastructure) are likely to peak this fi nancial year and coal and liquid natural gas related investment is likely to peak in 2014-15, suggesting a peak in aggregate around 2014.

In other words, the boom in mining investment has 18 months or so to run before it peaks and starts to subside back to more normal levels. But what can be said though, is with the cancellation of marginal projects that were in the preliminary stage, the end is coming into sight.

Finally, MB III or the pick-up in export volumes flowing from the surge in mining investment in iron ore, coal and liquefied natural gas will start to get underway around 2014-15.

Heading towards a more balanced economy

Talk of the end of the mining boom has created a bit of nervousness regarding the outlook for Australia. However, the reality is that the current stage of the mining boom focused on
mining investment has not been unambiguously good for the economy and its inevitable end should hopefully see Australia return to a more balanced economy.

It was always thought that after two or three years the surge in mining investment would settle back down as projects ran their course. Trying to do a whole lot of projects in a relatively short space of time was always fraught with the threat of excessive cost
pressures and an excessive surge in supply. We are now seeing market forces kicking in to rationalise resource projects and so the more marginal projects are being delayed. This is a good thing as it will reduce cost pressures, leave work for the future and reduce the
size of the commodity supply surge over the decade ahead thereby helping avoid a crash in commodity prices.

The cooling down of the mining investment boom should help lead to a more balanced economy. MB II has not been good for big parts of Australia. With roughly 2 percentage points of growth coming from mining investment alone it has really put a squeeze on the
rest of the economy. Housing and non-residential construction, retailing, manufacturing and tourism have all suffered under the weight of higher-than-otherwise interest rates and a surge in the A$ to 30-year highs.

What’s more the boom in mining investment has meant that the Federal Government has not seen the tax revenue surge it got last decade, so last decade’s regular tax cuts have not been possible and this has weighed on household income.
This is all evident in the Australian share market which has underperformed global shares since late 2009, with the resource sector being the worst performer over the last year as resource sector profits have fallen 15% or so.

So, the end of the mining investment boom, to the extent that it takes pressure off interest rates and the A$, should enable the parts of the economy that have been under the screw for the last few years to rebound, leading to more balanced growth. This is also likely to be augmented by a pick-up in resource export volumes equal to around 1% of GDP from around 2014-15 according to the Bureau of Resource and Energy Economics.

Of course a risk is of a timing mismatch around 2014 as investment slows down with other sectors taking a while to pick up. To guard against this the Reserve Bank will clearly need to stand ready to respond with lower interest rates.

The bottom line is that the end of the mining investment boom in a year or two won’t necessarily be bad for the Australian economy and will likely see a return to more balanced growth.

Concluding comments
It’s premature to call the end of the mining boom just yet. The peak in mining investment probably won’t be seen until 2014 and thereafter actual mining production and hence exports will start to pick up. However, the best has probably been seen in terms of commodity price gains and the end of the investment boom is starting to come into sight.
While there may be the risk of slower growth as the Australian economy shifts gears away from mining investment in 2014 to mining exports, construction and other parts of the economy that have been subdued, the end of the investment boom should lead to a more balanced economy reflecting less pressure on the interest rates and the A$.
For investors there are several implications including:

  • Ongoing pressure for lower interest rates as the risk of an overheating economy subsides. This means that term deposit rates are likely to fall further in the years ahead.
  • The best has likely been seen for the A$, implying less need to hedge global shares back to Australian dollars.
  • Resources shares are currently cheap and should experience a cyclical rebound when confidence in global growth improves.
  • However, beyond a short-term bounce it’s likely that the cooling of the mining boom will allow a return to a more balanced share market with domestic cyclicals likely to perform better.

This material has been provided for general information purposes and must not be construed as investment advice. This material has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances prior to making any investment decisions and should read the relevant Product Disclosure Statement.

Published in Australian Economy