With around 30 percent of listed company earnings sourced overseas, a 10 percent rise in the Australian dollar would typically cut earnings by around three percent. But due to a myriad of factors, none the least being hedging structures, offsetting revenue and input costs, the correlation between the Aussie dollar and share price movements has declined in recent years. As a result, stock selection from a currency perspective has become increasingly difficult to disentangle from macroeconomic conditions or stock-specific factors.
After falling to a low of US$0.81 early in 2010, the A$ has appreciated 20 percent having recently hit parity with the US$ six months ago. While some currency experts expect the A$ to nudge US$1.10 by year end, few see it straying too far from parity any time soon.
The A$ is clearly benefitting from higher commodity prices. But assuming the recent rise in commodities is a function of short-term factors that will eventually see an end – such as the conflicts in Libya – then Kathy Lien director of currency research with Global Forex Trading thinks the A$ is currently nearing its peak.
The A$ fell below parity on March 15, after concerns of a nuclear meltdown in Japan. Despite regaining some recent ground, she believes that the A$/US$ will be back at parity by mid-year and below parity by year end. In turn, she says a weaker currency and less restrictive policy by the RBA should provide some relief for shares. “The market is pricing in no additional rate hikes from the RBA this year, and I don’t think Forex traders have taken this into consideration because they have clearly been bidding up the A$,” says Lien.
Sue Trinh senior currency strategist with RBC Capital Markets agrees that the A$ is starting to look like its close to peaking. Given the headwinds courtesy of Eurozone debt issues, and a likely floor to further weakness in the US$ later this year – pending further tightening by ‘The Fed’ – Trinh says the A$ has reached levels, which from a longer-term perspective look like it’s getting a little rich. She expects the A$ to be back at US$0.99 by mid-year, and US$0.97 by year end.
However, not all analysts are quite so bearish. Kien Trinh quant analyst with Patersons Securities expects momentum within key factors – like a strong domestic economy, strength in commodity prices, widening interest-rate differentials, and significant liquidity injections further depreciating the US currency – to keep the A$ above parity for at least the remainder of 2011. He expects the A$ to reach US$1.04 by mid-year, and US$1.06 by year end.
In similar vein, Michael Knox Analyst with RBS Morgans says the underlying driving force behind further upside in the A$ is the magnitude of the US budget deficit. Expected to be around 10.9 percent of US GDP, Knox expects this historically high deficit to place further downward pressure on the $US over the next year. “The $US is going down because the US is manufacturing a huge volume of $US liabilities coming to the market in the form of US Treasury bills and bonds,” says Knox. “The volume of them is so great that the only way the market will clear on a global basis is for the real value of the $US to fall.”
Consequently, Knox says the direction of the $A is up, and his model pegs current fair value for the $A at $US1.03. He says the greater the perception that the trend for the $A is down, the more likely that the $A/$US could become more oversold in coming months. “Should this happen, it will be followed by a rally in the A$ to wipe out all the shorts, and by year’s end, market participants will be talking about new highs for the A$.”
Taking an even more bullish outlook, Shane Oliver AMP Capital Investors chief economist expects the A$ to trade as high as $US1.10 by year end on the underlying strength of increasing demand for Australian commodities. While the A$ dipped following Japan’s natural disasters, he expects the country’s pending reconstruction phase to provide yet another kicker to global commodity demand. “I expect an average around $US1.10 is likely in the years ahead, unless the global economy collapses again,” says Oliver. “For investors, a rising $A reduces the value of offshore investments, unless they are hedged back to Australian dollars.”
So assuming Oliver and Co are right, what impact is the historically high A$ environment having on equities? As a guiding thematic, cyclical stocks tend to outperform defensives in a rising A$ environment. That’s because the A$ is a function of improving global economic conditions.
In theory a rising A$ should benefit companies that import goods from overseas, notably retailers. But given that they hedge their orders six-12 months ahead of their sale period – using forward exchange contracts – the benefit of a rising A$ could take 12 months to be realised.
While a strong $A should have boosted their margins, retailers chose to discount them within what’s been an historically weak consumption environment. As a case in point, Harvey Norman (HVN) attributed much of its recent profit down-turn to price ‘deflation’ in key categories driven by the strong A$. So severe was the decline in its margins that fashion chain Colorado warned that it’s in danger of breaching financial covenants.
Conversely, a rising A$ also makes it difficult for exporters – especially companies in agriculture and manufacturing sectors – as it reduces their price competitiveness in overseas markets, while property trusts with unhedged overseas exposure may also be at risk.
But due to top-line revenue growth outweighing the ‘second order’ earnings impact, the analysis of Kien Trinh quant analyst with Patersons Securities suggests that resources, energy, steel, mining services, banks and building materials tend to do better in a rising A$ environment.
When it comes to resources, Trinh says the effect of rising commodity prices and stronger demand for goods & services far outweigh the translation effect of offshore earnings. “But both Iluka (ILU) and Alumina (AWC) defy this trend in the resource space as they have minimum hedge exposures – other than through near-term forward purchase of currency – to meet operating requirements,” says Trinh.
On the flipside, he says underperforming sectors within a rising A$ environment typically include: Telecos, wagering, consumer staples and healthcare sectors. He says the sustained strength of the A$ should benefit importers and industrial stocks with limited overseas exposure including: Qantas (QAN), Virgin Blue (VBA), The Reject Shop (TRS), Goodman Fielder (GFF), Pacific Brands (PBG), Wesfarmers (WES), JB Hi-Fi (JBH), Coca Cola Amatil (CCL), Harvey Norman (HVN), Woolworths (WOW), ALESCO (ALS), Toll Holdings (TOL), Computershare (CPU) – and a selection of media stocks, including Ten Network Holdings (TEN), Seven group (SVW), and West Australian newspapers (WAN).
But Trinh says the best performers when the A$ is rising include: Fortescue Metals Group (FMG), Aquarius Platinum Ltd (AQP), Paladin Energy (PDN), Boart Longyear (BLY), Oz Minerals (OZL), Oil Search (OSH), Bluescope Steel (BSL), Leighton Holdings (LEI), Onesteel (OST), Alumina Ltd (AWC), Sims metal (SGM), Nucoal Resources (NCM), Worley Parsons (WOR), and Macquarie Group (MQG).
Conversely, he says stocks most vulnerable to a sustainably high A$ would be those in the defensive space with offshore earnings exposed to both low price sensitivity and high earnings translation of the rising A$. Based on these metrics, he says the worst performers in the event of a rising A$ include: Resmed (RMD), SAI Global (SAI), Ansell Ltd (ANN), Aristocrat Leisure (ALL), CSL Ltd (CSL), Brambles (BXB), Billabong (BBG), Fosters Group (FGL), Cochlear (COH), and QBE Insurance (QBE), Sparks Infrastructure Group (SKI), Coca Cola Amatil (CCL), Goodman Fielder (GFF), Metcash (MTS), Amcor (AMC), CSL Ltd (CSL), Tatts Group (TTS), Telstra (TLS), Ramsay Healthcare (RHC), Sonic Healthcare (SHL), AGL Energy (AGK), Computershare (CPU), Woolworths (WOW), Tabcorp (TAH) and CFS Retail Property (CFX).
Assuming we have seen a structural shift in the A$/US$ relationship, Roger Leaning head of research with RBS Morgans says the biggest impact will be on importers and exporters and how it impacts their supplier/consumer behaviour. Leaning says stocks like GWA Group (GWA) or Brickworks (BKW) are less exposed to a ‘currency hit’ due to the natural hedge that comes from a diversity of local and internationally sourced product.
But on the flipside, he says retailers and distributors of domestic goods like Alesco (ALS), and Penrice Soda Holdings (PSH) are more likely to experience margin squeeze. Also challenged by a high A$, adds Leaning are those professional services firms like Sedgman (DM), Clough Ltd (CLO) and Industrea (IDL) that are less price competitive when operating internationally.
“Investors should keep a close eye on any company’s hedge book to ascertain the transaction affect of bringing offshore profits back home. But the decision whether to hold a stock should always come down to core underlying earnings and future growth aspirations.”
|When the A$ moves up|
|Best performers||Worst performers|
|Fortescue Metals (FMG)||Resmed (RMD)|
|Aquarius Platinum (AQP)||Goodman Fielder (GFF)|
|Paladin Energy (PDN)||Spark infrastructure (SKI)|
|Boart Longyear (BLY)||Ansell Ltd (ANN)|
|Oz Minerals (OZL)||Cochlear (COH)|
|Oil Search (OSH)||Coca Cola Amatil (CCL)|
|Bluescope Steel (BSL)||Metcash Ltd (MTS)|
|Leighton Holdings (LEI)||Amcor (AMC)|
|Alumina Ltd (AWC)||CSL Ltd (CSL)|
|Sims Metal (SGM)||Tatts group (TTS)|
|One Steel (OST)||Telstra (TLS)|
|Newcrest Mining (NCM)||Brambles (BXB)|
|Worley Parsons (WOR)||Ramsay Healthcare (RHC)|
|Macquarie Group (MQG)||Fosters Group (FGL)|
|Sonic Healthcare (SHL)|
|AGL Energy (AGK)|
|CFS Retail Property (CFX)|
Source: Patersons Securities
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