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Since the floating of the exchange rate a few decades ago, the commodity-based Aussie Dollar (AUD) has experienced broad valuations in line with global and domestic economic cycles.
The Currency Drivers.
In the long run, the Aussie dollar exchange rate responds to changes in economic fundamentals and in the short run, flows related to portfolio and balance sheet adjustments by financial institutions can be useful in explaining sharp movements in the exchange rate.
Long-Run
Historically, it has been possible to explain broad movements in the Australian dollar exchange rate by considering two important economic fundamentals:
- the terms of trade which typically move in line with global commodity prices, and
- the differential between domestic and foreign interest rates.
The emerging strength of China and India provides support for commodity prices. It's no secret that the Australian economy is fuelled by the demand for commodities overseas. This long-term offshore commodity demand cushions our economy.
The off-shore economic cycles also play an inter-locking role. If inflation is low and there are low expectations of an interest rate rises in Europe and/or the US, it is more likely that our interest rates will remain high compared to them. If interest rates in Australia are noteably higher than in the US or other stable economies, or expected to be higher, then financial institutions and the well-heeled globally will be more willing to invest their money in an Australian bank account than there. When rates fall too low (as with the global financial crisis) any increase in global demand will positively impact the Aussie economy, pushing up interest rates versus other G20 economies.
All these factors point to the AUD remaining at higher levels than in the past. Some analysts predict that the AUD should be well supported over the US$0.8000 level for the short to medium-term.
Short-term Supply and Demand Dictate Day to Day Moves.
Even though general economic developments are useful in understanding the long-run cycles in the exchange rate, on a day-to-day basis market commentators often discuss exchange rate movements in terms of the balance of supply and demand for Australian dollars among the various participants in the foreign exchange market.
This includes:
- the foreign exchange flows of importers and exporters,
- investors such as superannuation and hedge funds,
- central banks,
- financial intermediaries and
- foreign exchange dealers.
Some of these participants, especially foreign exchange dealers and ‘macro’ hedge funds, are particularly attentive to new public information about economic developments, such as data releases, and therefore their trades play an important role in ensuring that the exchange rate adjusts to changes in macroeconomic fundamentals.
However, many of the flows through the foreign exchange market, such as those relating to trade or long-term foreign investments, are not generated directly in response to the latest news about economic fundamentals, but rather reflect the specific transaction needs of market participants for foreign exchange at that time.
The next question is what does a stronger AUD mean for the local economy?
The simple answer to this is that a stronger AUD means that imports become cheaper but exports become dearer. Therefore companies that import are paying less in AUD for their goods. Those that on-sell them without decreasing the sale price enjoy a rising profit margin. On the other hand, those companies that are exporting may find that they will need to lower prices to be able to compete on the global market place, subsequently experiencing decreased margins. This situation was reversed in recent years when the AUD was at much lower levels.
The AUD variation causes different problems for different businesses. One way to try to limit this is by hedging currencies. In theory, this decreases the risk any adverse currency movements have upon the company's balance sheet. Others believe that the cost of hedging your position far out ways the benefit. It would be a good idea to point out that some companies have got their hedging position so wrong in the past that they have actually got into real strife.
What companies on the Australian Securities Exchange benefit from a rising dollar and which ones don't?
Companies that are not benefiting from the rise in the AUD are ones who earn a large proportion of their income is USD. The reason is simple; the weakness in the currency as compared to the AUD means that profit earned over there is not worth as much. Furthermore, company forecast will not be met as AUD keeps appreciating against the USD. Companies that have operations in the US include Brambles (BXB), Resmed (RMD), CSL, James Hardie (JHX), Boral (BLD), Aristocrat Leisure (ALL), Lend Lease corporation (LLC), Billabong (BBG) and Newscorp (NWS) just to name a few. These companies have to find ways to minimise the effect of the rising AUD, generally through hedging practices. Each company will have a section in their company's annual report highlighting how much of their future income has been hedged.
Some of the miners have also been hit recently with our currency appreciation somewhat offsetting the appreciation in commodity prices. These companies include our gold and oil miners like Newcrest Mining (NCM).
Alternatively, companies that are net importers have benefited greatly, like Harvey Norman (HVN). It is recommended that you don't place your investment decision solely on a company's exposure to predicted currency prices. A better strategy is to find companies with good business models first, then assess their exposure to currency movements. As stated above the annual report will indicate a company's hedging strategy.
