Unhedged still a good choice

Print This Post A A A

The Australian dollar has taken a notable tumble in recent months, and some investors may fear they’ve missed the boat in terms of taking on greater offshore investment exposure. In reality, however, the decline in the $A may well have only just begun, and offshore – unhedged – investments still seem worthy of serious consideration.

The outlook

The drivers of financial markets change over time. One of the major investment themes of the past decade – namely the rise of China and the associated rise in global commodity prices – is likely to evolve in new ways over the next decade. This is likely to be associated with a weaker Australian dollar, and new country and sector leaders across the global economy in the next few years.

For starters, the Chinese economy is slowing as it grows in size and becomes more complex. Services, consumer spending and less fossil-fuel intensive industrial activity will figure more prominently in the China of tomorrow, which will reduce its once ferocious appetite for Australian coal and iron ore.

At the same time, global production of coal and iron ore is being ramped up in the typically lagged response to the earlier high level of prices. The downward phase of the commodity price cycle will tend to favour net-commodity consuming nations – like China and the US – over producers like Australia and Brazil.

Slowly but surely, the US economy is also gathering strength and the Federal Reserve is inching closer to winding back the extreme level of monetary accommodation of recent years. To be sure, the US economy remains in a fragile state, but it’s much better placed from a productivity and demographic perspective than its European and Japanese counterparts.

The prospect of higher US interest rates – and reaffirmation of the greenback as the world’s reserve currency – is already being felt in global currency markets with some lift in the US dollar from what had been historically cheap levels. As the US dollar cycle turns up, the Australian dollar cycle will inevitably turn downward.

Of course, Australian miners may still fare relatively well in this environment. While slowing, China’s demand will still remain strong and mining export volumes are likely to rise. Along with other exporters, miners will also benefit by a cheaper $A as it will boost the local currency value of offshore earnings. But unlike over much of the past decade, miners may not be the clear sector leaders they once were.

How low could the $A go?

Note that over the past few decades, it has averaged around US 75c in nominal terms. Over this period, moreover, Australian inflation has tended to be a bit higher than in the United States – such that for the currency to equal its long-run average in real terms (of more relevance for price competitiveness), it needs to be around US 65c today.

Against this of course, there is the strong feeling among commodity analysts that while commodity prices will likely fall further, they will remain above their longer-run average due to rising production costs and strong ongoing demand from China. Taking all this together, it’s still not inconceivable that the $A drops to the low US80c range – or even the mid-US70c – over the next few years. Such a drop will enhance the $A value of investment in foreign markets, be they in cash, bonds or equities.

Where to invest?

There’s a plethora of choice, but it’s hard to beat the biggest and most liquid market in the world – namely the United States. Even in a cyclically weak economy, corporate America’s profit share has continued to trend higher, and it’s hard to see such profit performance worsening as the economy improves.

At the other end of the spectrum, China’s share market has been beaten down badly in recent years and appears quite cheap for an economy still capable of growing at a 7.5% annual pace. Frontier Asian economies, such as Vietnam and Bangladesh, are also worth considering, as China gradually loses its cost competitiveness in labour intensive manufacturing.

As for sectors, a renaissance in the technology sector appears underway, given the digital revolution and convergence in media technologies. The ever dependable health care sector is also well placed to benefit from new medical technologies and rich ageing populations in the developed world. Emerging market financial liberalisation might also favour their financial and consumer sectors as – rightly or wrongly – once credit-starved households are lured toward greater leverage.

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.

Also in the Switzer Super Report:

Also from this edition

View More Articles