Nervousness about the trajectory of US interest-rate rises this week punctured the rally in interest-rate-sensitive stocks. It also took a little steam out of the Australian dollar and created an opportunity to benefit from a gradual easing in our currency in FY17. Bears have lined up this year to predict a sharply lower Australian dollar. BT Investment Management in June said our dollar could hit US40 cents, such is the deteriorating state of the government’s fiscal position. AMP Capital says our currency could fall to US60 cents.
Clime Asset Management recently predicted that a global currency war will erupt in 2016-17. Large nations will attempt to drive their currency lower to stimulate economic growth, in turn prompting others to do the same to maintain their relative export competitiveness. But the currency bears have been wrong so far this year. The Australian dollar rallied from a low of US68 cents in January to US74.4 cents. It traded as high as US78 cents in May, defying sceptics, who believed it was badly overvalued, and frustrating the Reserve Bank.
Chart 1: Australian dollar versus US dollar over one year
Source: Yahoo
Investors who piled into unhedged international equities at the start of FY16, in anticipation of further falls in the Australian dollar, had lousy returns. International shares (unhedged) were the second-worst-performing asset class in FY16 with an almost zero return, Vanguard data shows.
They were due for a bad year. International equities delivered a 33% return in FY13 – the best of any class – as our dollar retreated from parity against the Greenback. They returned more than 20% in FY14 and FY15.
Chart 2: Australian dollar over five years
Source: Yahoo
Investors had good reason to expect further falls in the Australian dollar relative to the Greenback in FY16. Lower commodity prices were predicted as the global economy slowed – a terrible trend for a country that relies heavily on raw-material exports for income.
The Reserve Bank was expected to cut the official interest rate at least a few times in FY16, reducing the yield differential between Australia and other markets, and taking pressure off the currency. The RBA duly delivered but it had little effect on lowering our overvalued currency. Meanwhile, the US Federal Reserve was taking longer than expected to raise interest rates. The market was lulled into a “lower for longer” mentality with US rates, a reason why interest-rate-sensitive assets rallied hard this year as investors chased them for yield.
In Australia, infrastructure stocks such as Sydney Airport and Transurban delivered stunning returns as investors paid ever higher prices for their defensive yield. I had been bullish on both stocks for years, but went cold on them for the Super Switzer Report in June 2016. I nominated Sydney Airport and Transurban as “stocks to sell before June 30” and wrote: “Infrastructure stocks will underperform if US interest rates rise faster than expected in the next few years, a risk the market might be underestimating.”
Sydney Airport (SYD) and Transurban (TCL) have both fallen about 14% from their 52-week high – and more falls seem likely this week as the US equity market retreats.
A turning point for financial markets?
Commentators were quick this week to pronounce that US shares had reached “the big top” and that the great bull run in equities in the past few years was ending. I’m not as convinced that the US equity market has entered a major corrective phase, largely because US interest-rate rises are likely to be gradual rather than race higher and global economic growth remains problematic. The market was primed for a US interest-rate scare. Volatility, as measured by the US VIX index, was subdued and the market had been eerily quiet. The chart below shows the big spike in volatility this week. The previous spike was after the British referendum to leave the European Union.
Chart 3: Volatility index spikes higher
Source: Yahoo
Comments from a US Federal Reserve voting member last week that the central bank could resume gradual rate increases were enough to spark a 400-point fall in the Dow Jones Industrial index. With the market near its top, and investors worldwide addicted to central bank easy-money policies, it did not take much for investors to panic.
Nevertheless, the Fed’s choreographing of US interest-rate rises is a clear signal that it wants to raise rates this year. The spike in volatility is about the market betting whether the rate hike will be in September or December. But the broad direction in US rates, up, is clear.
Bigger headwind for Australian dollar
Rising US interest rates should drive the Greenback higher in FY17. That’s bad news for the Australian dollar – or good news if you position your portfolio correctly. It’s also bad for gold bullion. Gold historically has a negative connection with the US dollar; it rises when the Greenback falls and vice versa, although the relationship is not always clear cut.
I wouldn’t give up on gold just yet, principally because US interest-rate rises will be slow and demand for gold as a safe-haven asset will remain strong in FY17, given the prospect of heightened market volatility and growing risk of global economic shocks.
But US-dollar gold is due for a breather after strong gains this year. The Australian-dollar gold price, the key issue for local producers, looks more interesting, given the potential for a fall in our currency to offset lower gold bullion prices, should they occur.
A higher Greenback, and lower Australian dollar, should reduce pressure on the Reserve Bank to cut the official cash rate again this year. That, and an Australian economy doing better than expected, at least for now, strengthen the case to keep rates on hold this year.
A rising US dollar will also weigh on commodity prices, a reason why our big miners tumbled this week. When the US dollar strengthens against major currencies, commodity prices tend to drop, and vice versa. The US dollar is the benchmark pricing mechanism for most commodities. But the Reserve Bank believes our terms of trade will remain close to current levels.
Taken together, the prospect of rising US interest rates and lower commodity prices should drive the Australian dollar lower in FY17, offsetting a pause in local interest-rate cuts.
Profiting from a lower currency
Forecasting currency prices is a mug’s game: too many factors influence short-term prices. My sense is that falls in the Australian dollar in FY17 will be slow and modest: I don’t see US rates going up in a hurry and our economy is still relatively attractive for foreign investors.
But the Australian dollar’s trend is down and US68 cents by the end of FY17 seems a reasonable bet. That would retest our dollar’s low of US68 cents in January 2016. If our dollar breaks support around the US68-70 cents range, it could go lower in a hurry, but it’s too soon to know.
The best way to play a lower Australian dollar is through currency instruments. Investors too often plump for Australian companies with a higher proportion of US-dollar earnings, which are worth more when translated back into our currency.
Lots of factors affect their share prices, including various currencies, not just the US dollar. Buying these stocks because of a play on the currency means taking company and equity market risk, which is unnecessary for investors who want pure currency exposure.
That said, the likes of Macquarie Group (MQG), Computershare (CPU) and James Hardie Industries Plc (JHX) would have bigger earnings tailwinds if the Australian dollar falls. Macquarie looks the pick of the bunch as it derives more of its global revenue from annuity-style businesses.
Using an Exchange Traded Fund (ETF) that provides leverage to a lower Australian dollar versus the greenback is an option for investors who want low-cost currency exposure through the Australian Securities Exchange.
The BetaShares US dollar ETF (USD) aims to track the change in the price of the US dollar relative to the Australian dollar, before fees and expenses. If the US dollar goes up 10% against the Australian dollar (our dollar falls), the ETF is designed to go up 10%.
The BetaShares US dollar ETF is a useful tool to profit from a view that the Australian dollar will fall against the US dollar, or to diversify portfolios and hedge against currency risk.
The ETF has a three-year annualised return of 5.3% to August 31, 2016. It is down almost 4% over three months. The ETF should do better as the US dollar slowly appreciates against the Australian dollar during FY17.
Chart 4: BetaShares US dollar ETF
Source: Yahoo
If I’m right and our currency retests US68 cents in FY17, investors would eke out about a 9% gain in the ETF, before fees, from current levels. It’s not earth shattering, but betting on a lower Australian dollar this FY17 seems like a higher-probability trade, and a near double-digit return is attractive in a low-growth environment.
This idea suits more experienced, active investors who can keep an eye on currency movements. They can be volatile and confound the pundits. Investors with lower risk appetite should get their currency exposure through a well-performed international equities fund or listed investment company that does not hedge currency exposure.
Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at Sept 14, 2016.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
