The Australian dollar showed resilience during the second half of 2016 due to a number of variables. Commodity prices rallied, the US Federal Reserve pushed back interest rate hikes, the market started pricing out interest rate cuts from the Reserve Bank of Australia (RBA) and Australian and global economic data was generally positive.
The Australian economy benefits when the Australian dollar is below US$0.70, to assist the currency-sensitive sectors of the economy as mining investment continues to unwind and remains a drag on growth.
Despite the current strength in the Australian dollar, it is likely the currency will head lower during the coming year. This is because recent commodity price gains are unlikely to be sustained at the same pace as they have enjoyed in recent months.
The US dollar is expected to continue rising, which is another factor that will dampen the local currency. There is still the risk the Reserve Bank of Australia (RBA) could cut the cash rate again this year, which would also put downward pressure on the currency.
A lower currency generally assists growth in the non-mining sector. In contrast a high exchange rate reduces GDP growth over the medium term, although the impact across industries is quite varied.
On one hand, an industry with a high level of exports as a proportion of total sales or production will suffer from a high/appreciating currency because the price of the goods lifts on the global market. This potentially switches demand for the product to a lower priced competitor.
However, an appreciating Australian dollar usually leads to lower input prices for importers, benefitting margins. In contrast, a depreciating Australian dollar will lead to higher input prices, detracting from margins.
As a higher currency lowers the price of imported goods, industries with a high level of imported competition could be negatively impacted. This would happen if competitors drop their prices and local operators have to follow suit, leading to potential margin pressure.
The mining, manufacturing and other business services sectors are those most likely to experience margin pressures as a result of a higher dollar.
However, it’s important to point out that it does appear like Australian firms are now better placed to deal with a higher Australian dollar compared to few years ago. This is because the Australian dollar was valued at around parity with the US dollar from 2011 to 2013. This required businesses with exposure to foreign exchange markets to account for currency movements in their business plans, perhaps more so then they may have done in the past.
In terms of implications for investors, a lower Australian dollar will be helpful in further assisting a recovery in non-mining business investment. The depreciation in the Australian dollar during the past two years has been a big beneficiary to service exports. This is particularly the case with education and tourism, which are some of Australia’s largest export groups.
With mining investment continuing to detract from growth, stronger non-mining activity is required to keep GDP growth at a respectable level, which in turn should help profit growth for Australian companies.
But, if businesses are indeed now better equipped to deal with a higher Australian dollar, then a smaller than expected currency depreciation would still generate the necessary positive growth impulse to the economy.
We remain of the view that the pressures facing the Australian dollar are likely to push the currency lower from here, to below US$0.70 during the next year.
This is particularly the case given there is more upside pressure on the US dollar as markets factor in more interest rate hikes in the US in 2017.
Against this backdrop, it makes sense for investors to maintain an exposure to un-hedged global assets as these will rise in value if the Australian dollar falls.
However, any adjustment to a self-managed super fund portfolio in light of currency movements should be done with the fund’s overall investment goals and strategy in mind.
Currency movements and their impact on an investment portfolio is a complex area, and it often pays to seek advice to ensure the portfolio won’t be adversely affected should there be swift and decisive movements in currency markets.
About the author:
Diana Mousina is an Economist within the Investment Strategy and Dynamic Markets team at AMP Capital. Diana’s responsibilities include providing economic and macro investment analysis and contributing to the performance of the dynamic markets fund.
Source: AMP Capital 9 February 2017
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