Does your SMSF need foreign exposure?

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Despite falling export commodity prices over the past year, the Aussie dollar has so far remained remarkably firm, leading to concerns for Australia’s export competing industries.

The combination of falling export prices and a high Australian dollar has not helped mining sector profits and the sector has significantly underperformed the overall share market over the past year.

But will the Aussie remain firm, or ease back to normal levels? There are investments out there that will let you hedge your bets.

Diversification benefits

Internationally exposed investors need to be aware of the impact of the Aussie dollar because currency shifts can affect the Aussie-dollar value of unhedged offshore equity or fixed-income investments.

Currencies offer another means for risk averse investors to diversify their portfolios – even if you want to remain in low risk cash products. For example, it’s easy to spread risk among a number of currencies. Should the Australian dollar fall, for example, the value of US dollar or euro cash holdings would rise in Australian dollar terms.

So where next for the Aussie?

Against the US dollar, the Aussie peaked earlier last year at around US$1.10, before sinking as low as 94 US cents late last year. It has since rebounded in line with stronger global equity markets and was last seen hovering around US$1.055. The Aussie also remains below its pre-global financial crisis peak against the Japanese yen.

The real standout has been the euro, against which the Aussie has marched on to record highs. In turn this reflects the desire of European investors – and in particular European central banks – to diversify their foreign exchange holdings given pressures on the euro and sovereign debt credit-rating downgrades across the globe.

On a trade-weighted basis, and allowing for inflation differentials, Australia’s real exchange rate remains near record highs and hasn’t followed export commodity prices down in sympathy.

Since mid-2011, Australia’s sky-high export commodity prices have fallen from their peaks due to both slowing growth in China and a belated pick-up in global supply. Spot iron ore prices have fallen from around US$180 to US$120 a tonne, while spot coal prices have fallen from US$120 to US$90. The Reserve Bank of Australia’s (RBA) index of non-rural commodity prices in US dollar terms is down around 13% from its peak in early 2011.

But can the record high levels last?

If Europe’s problems get a lot worse, the safe-haven flows into Australian-dollar investments could intensify.

Even at only 3.2%, Australian 10-year government bond yields remain relatively attractive by international standards – especially among the dwindling number of countries that retain a triple-A credit rating.

Adding to the risk of heightened inflows, the European Central Bank has recently indicated it stands ready to print cash to buy up sovereign bonds in troubled countries such as Spain and Italy – which could be a further negative for the euro.

The outlook

Longer-term, however, it still seems there’s more downside than upside risk to the Australian dollar. With global commodity supply picking up and commodity prices easing, the continued high value of the Aussie increasingly risks crushing local trade-exposed sectors – so much so that it could eventually goad the Reserve Bank into cutting interest rates more than otherwise and/or intervene in currency markets. The economy simply can’t support the Aussie staying this high in the absence of a continued commodity price boom.

What to buy

Investors might consider using this period of unusual Aussie dollar strength to gain offshore currency exposure. These days, with exchange traded funds (ETFs), one of the easiest ways is through buying unhedged exposure to foreign equity markets – such as via the iShares S&P 500 ERTF (IVV) or even iShares Europe 350 (IEU). And if you only want foreign cash exposure, Beta Shares offers a US dollar (USD) or Euro (EEU) cash product that will gain in Aussie-dollar terms when and if the local currency begins its downward correction.

Of course, picking currency direction is never easy. But given the volatility in global currencies, these days, investors should not ignore the diversification benefits – and potential reduction in portfolio volatility – that would come from spreading cash and equity exposure among a number of different currencies.

Important information: 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. Anyone should consider the appropriateness of the information in regards to their circumstances.

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