The strengthening of the Australian dollar over the past year has been remarkable: from 57 US cents at the height of the COVID Crash in March 2020, the Aussie has surged as much as 37%, to 78 cents in January, before easing back to its present level at 76 cents.
The exchange rate is an ever-present fact of economic life, and it is difficult to get a handle on it – the foreign exchange market sets the exchange rate, but the simple fact is that the exchange rate is part of a pair: there are always two currencies involved, and thus, two views.
The Australian dollar is usually considered a “commodity currency” – because it derives much of its valuation from Australia’s export of iron ore, coal, LNG and other raw materials – and this means that it has come to be seen as a “risk-on” currency, that surges when the global economic outlook appears positive.
However, the A$/US$ exchange rate is also affected by the market’s view of the US$ – the mighty greenback, the world’s reserve currency, at least for now. It is usually considered a “risk-off” currency, a safe-haven from economic turmoil. But there is a new US Administration in town, with plans for eye-watering amounts of stimulus, both traditional and “green”-oriented. This massive stimulus spending from Washington is expected to require large-scale bond issuance and push the US dollar lower – which results in a rising A$ in US$ terms.
That combination of expected rises in commodity prices as the global economy responds to stimulus efforts coming out of the pandemic, and the lower US$, is where analyst forecasts of US 80 cents–US 85 cents for the A$ in 2021 come from, despite the slight recent retreat to 78 cents.
Generally speaking, a stronger A$ is bad news for shareholders in the Australian companies that actually report their results in US dollars: the twice-yearly dividend payments will be less when converted to A$, depending on the exchange rate at the time the dividend hits their bank accounts. These stocks should also show weaker share price when the A$ is strong.
In this category are biotech giant CSL, diversified miners BHP and Rio Tinto, iron ore miner Fortescue Metals Group, gold miner Newcrest, building materials producer James Hardie, oil and gas heavyweights Woodside Petroleum, Santos and Oil Search, global securities registration leader Computershare, insurer QBE, logistics giant Brambles, medical device heavyweight ResMed, electronics design software company Altium and packaging group Amcor.
These companies also report their results on a “constant currency” basis, which eliminates foreign exchange movements from one year to the next. But Australian dollar dividends will be reduced if the A$ appreciates.
Then there are the Australian companies that earn revenue overseas – if it is in the US dollar, the stronger the Australian currency is against the US dollar, the less revenue they earn in A$ terms. The stronger the A$, the less A$ each ‘unit’ of US dollar-denominated revenue buys when it’s converted to A$ in the reported financial results.
Companies with significant percentages of their revenue coming from offshore include Appen, Afterpay, Boral, Treasury Wine Estates, Macquarie Group, Worley, CSR, BlueScope Steel, Austal, Cochlear, Flight Centre, SDI, Carsales.com.au, Aristocrat Leisure, Ainsworth Gaming Technology, Hansen Technology, Reliance Worldwide, Seek, Sims, Orora, Mayne Pharma, Sonic Healthcare, GrainCorp, SomnoMed, Ansell, Breville, Adelaide Brighton, GWA, Bega Cheese, Incitec Pivot, Transurban, WiseTech Global, Nufarm and Orica.
Most of these companies use hedging contracts to reduce the volatility, but if the A$ goes above US 80 cents, translated earnings will suffer.
Of course, in the long run, the health of a company’s business, and the investor appetite for the shares, is more important than currency impacts on earnings in the short term. If the valuation is attractive and the profit outlook good enough, investors will buy the stock notwithstanding any headwind from the currency – above-market earnings growth is more important than the currency effect. (It is a similar story with buying an overseas-listed stock: get the stock selection right, and the currency risk will not matter in the long run.)
A good example of this situation is data annotation and artificial intelligence company Appen (ASX: APX). Most of its income is in US$, and it doesn’t enjoy a rising $A; also, COVID has cut into spending on digital advertising, and the big tech companies investing in AI projects, which caused downgraded earnings for Appen. As these latter two situations turn around, through 2021, the weakness in the Appen share price is unlikely to last long – even with a strengthening A$. APX looks to be a very attractive buy for those reasons, which are stronger than the currency effect.
BlueScope Steel (ASX: BSL) is another stock where the fundamental business outlook – backed by stimulus in the US – has seen earnings guidance lifted, and given investors good reason to buy the stock.
Global plumbing and water control systems manufacturer and supplier Reliance Worldwide (ASX: RWC) is another; so is global gaming machine supplier Aristocrat Leisure (ASX: ALL).
Biotech heavyweight CSL (ASX: CSL), oil and gas company Santos (ASX: STO), packaging leader Amcor (ASX: AMC), engineering company Worley (ASX: WOR) Electronic printed circuit board (PCB) design software company Altium (ASX: ALU) and shipbuilder Austal (ASX: ASB) all appear to offer very attractive value at current prices – despite the fact that all face a headwind from a stronger A$.
On the other hand, there are certainly situations where the risk of a rising A$ is not compensated-for by the actual state of the business, or the share price valuation.
As an example of the first, clearly the fight that Treasury Wine Estates (ASX: TWE) has on its hands to restructure its overseas markets while it deals with the tariffs that have effectively killed-off its Chinese market temporarily is a bigger issue than currency, but the combination spells “Avoid” for now.
An example of the second is Fortescue Metals Group (ASX: FMG), which is arguably a situation where the share price is a bit too full – and the exchange rate will affect the dividend, which is the major reason for buying the stock at these levels.
On FN Arena’s numbers, Fortescue, at the current price of $21.80, trades at a fully franked expected dividend yield of 12.5%, or 17.8%, grossed-up. On Thomson Reuters’ numbers, FMG offers a fully franked expected yield of 12%, or 17.1%, grossed-up.
Then again, even with a haircut on the yield that could be expected from a rising A$, the cashflows pouring-off Fortescue’s low-cost operations, if current iron ore prices prevail, would likely still generate a grossed-up yield well above the market average.
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