Seven years ago, the Australian dollar bought 48 US cents. Now it buys 91.2 US cents, having hit a 23-year high of 94.99 cents last month.
The dollar has traded in a 20-cent range against the US$ over the past year – its most volatile period in many years.
The Australian currency is rising because of higher commodity prices – like the “loonie”, or the Canadian dollar, it is perceived as a commodities-driven currency – and simply because the US$ is falling on the back of a weak US economy and growing market conviction that the US government and the Federal Reserve Board will not protect the Greenback. The US unit is vulnerable to the rise of the euro as an alternative world currency – and there is a huge global reservoir of schadenfreude (literally, pleasure from misfortune) almost willing that to happen.
Another key factor is the interest rate differential with the US. With the Australian official cash rate at a 12-year high of 7.25 per cent, and the US Federal Funds Rate heading in the opposite direction, at 2.25 per cent, the Australian cash rate is 500 basis points, or a full 5 per cent, above its US equivalent. That’s the biggest gap since 1991. At that kind of differential, the Australian currency is in high demand for ‘carry’ trades, where higher-yielding assets are bought with money borrowed in lower interest-rate currencies.
For the first time in more than three decades – certainly since it was floated in 1983 – currency market watchers are talking seriously about the “Aussie” reaching parity with the Greenback – even beyond.
While this is fabulous if you’re heading off to the US to shop or ski, let’s take a minute to think about its effect on the economy.
Generally speaking, a lower A$ is good for the Australian economy, making both our exports and local import-replacement more competitive. Exporters love a lower $A because they sell their goods (or services) in US$, but take their profits and report their earnings in $A.
An exporter paid US$100,000 in April 2001 banked A$209,400. Receiving the same US$ cheque today means banking A$109,200.
Obviously, companies with large amounts of overseas earnings suffer when the dollar rises. Shane Oliver, head of investment strategy at AMP Capital Investors, says about 30 per cent of Australian listed companies’ profit is sourced from overseas – so if the level of overseas earnings stays the same, a 10 per cent rise in the A$ automatically cuts earnings by about 3 per cent.
Medical stgice heavyweights ResMed and Cochlear make more than 95 per cent of their profits overseas. Ansell, BHP Billiton, Brambles, CSL, Brambles, James Hardie and PaperlinX all make more than 80 per cent of earnings offshore.
It is important, though, to distinguish between companies where the stronger A$ has a ‘translation’ effect on earnings – where the exchange rate merely affects the amount of foreign earnings when repatriated to Australia and reported in A$ terms – and companies where there is a ‘conversion’ effect, meaning that the stronger A$ actually has a direct effect on cash flow.
For example, Amcor experiences a translation effect, because it repatriates less in A$ terms when the A$ is strong, but does not suffer any competitive effect on its overseas businesses. In contrast, paper maker PaperlinX experiences a conversion effect, because it both exports paper and competes at home against imports in the copy-paper industry: a rising A$ makes both its exports and its import-competing products less competitive. A stronger A$ actually hits PaperlinX’s sales and cash flow, as well as profit.
According to broker Citigroup, PaperlinX is the most sensitive Australian stock to a rising $A: a 10 per cent rise in the currency against the US$ strips almost 40 per cent from PaperlinX’s earnings. In order, Citigroup says the next worst-affected stocks are Incitec Pivot, Sims, Gunns, BlueScope Steel, James Hardie, Dyno Nobel, OneSteel, Amcor, CSR, Aristocrat, AXA Asia-Pacific, QBE, Foster’s Boral, Billabong, Leighton, AGL Energy, Orica, IAG, Babcock & Brown, ABC Learning, Origin Energy and Suncorp.
But there are winners too: Citigroup says Pacific Brands is the mirror image of PaperlinX, boosting its earnings by almost 40 per cent for every 10 per cent rise in the A$. Others to benefit most strongly are Alumina, Newcrest, Just Group, Oxiana, Minara and Computershare.
Macquarie Equities says that about half of Just Group’s margin improvement in the December half-year was courtesy of the rising A$.
Qantas’ planes and fuel cost less with a higher A$: ABN AMRO estimates that every cent that the Aussie gains against the greenback adds $12 million to Qantas’ net profit. Harvey Norman’s goods are cheaper to bring into the country. Seven and Ten pay less for their foreign TV shows. There are winners and losers everywhere, so investors shouldn’t use the exchange rate in isolation to decide to buy or sell stocks.
Companies can offset their exchange rate exposure by hedging. For example, an importer might lock in an exchange rate to swap its US$ receipts into A$. By hedging, the exporter’s income is protected while the A$ is rising, but it takes away the benefit the company could get from a falling A$. As the A$ sank below 50 US cents, unhedged exporters were cheering all the way to the bank, but if hedged, they had limited their profits. Importers, on the other hand, don’t want to be hedged when the A$ is rising.
In a globalised investment world, investors are just like companies. Every serious investor should own overseas assets – meaning they have to think carefully about hedging.
For example, in the year to June 30 2007, international shares (as represented by the MSCI World Net Dividends Reinvested Accumulation Index) earned 23.8 per cent if hedged (expressed in local currency terms) compared to just 8.2 per cent if unhedged (expressed in A$ terms).
Over the five years to June 30 2007, international shares returned 14.4 per cent a year if hedged, compared to 5 per cent a year unhedged.
Clearly, with the A$ rising, hedging has been wise in recent years, but it hasn’t always been that way. Over the long period of the declining $A, being unhedged was better: in 2005, research firm Andex Charts estimated than an unhedged investment in international shares over 30 years had almost doubled the return of a hedged investment.
Between 1980 and 2007, says Andex, the results have converged: in that period, international shares earned an average return of 13 per cent a year, whether hedged or unhedged.