The AMP’s chief strategist and economist, Dr Shane Oliver says Friday night’s move by the Australia to just above parity with the US currency took "a bit longer than I first thought (he first forecast it in a article in late 2007) but the Australian dollar has finally broken through to parity against the $US."
He says this raises several questions – how did it get it here and is it sustainable? And what does it mean for the Australian economy and investors?
How did we get here?
The move through parity reflects a range of factors including downwards pressure in the value of the currencies of the major advanced countries led by the $US, strong commodity prices, a widening interest rate differential and strong economic fundamentals.
The global financial crisis has exposed a fundamental imbalance in the global economy and that is a high level of consumption and/or public debt in major advanced countries in contrast to low consumption and low debt in emerging countries.
A necessary part of the adjustment to rebalance the world is that currencies in the G3 (the US, Japan and Europe) need to fall relative to those in the emerging world.
This has been led by the $US and British pound but the Yen and euro will follow.
The outcome is a bit like a race to the bottom in such currencies, with the $US leading the charge, receiving added impetus lately as the US moves towards another round of quantitative easing which will involve another boost to the supply of US dollars.
Against the background of a falling $US, the strength in the Australian dollar is being given added impetus by a combination of:
• Rising commodity prices – they usually move inversely to the US dollar and their longer term trend higher is being driven by the commodity intensive demand in the emerging world.
Commodities account for 70% of Australia’s exports and prices for virtually everything from coal to copper, from gold to wheat have soared over the last 18 months taking Australia’s terms of trade to its highest level since the 1950s;
• While the US and other major industrial countries are moving towards more monetary easing, the Reserve Bank of Australia looks set to raise interest rates and so further widen the differential in rates with the US and other major countries; and
• The global financial crisis (GFC) has improved investor perceptions of Australia.
It is the only OECD country not to have succumbed to recession through the GFC; it has zero net public debt; & it is seen as well managed; and a relatively safe way to invest in the strong China story.
This favourable shift in perceptions is likely adding to long term upwards pressure on the $A.
But is it sustainable?
Since the Australian dollar floated in 1983 the general perception was that fair value was around $US0.70 and most fair value models for the $A constructed over this period confirmed this (as would be expected).
However, it’s likely this relatively narrow period of history misses the longer term perspective and the changed reality facing Australia.
Back in 1901 the equivalent of one Australian dollar bought $US2.40 and for most of the last century the $A was above parity against the $US.
The long term slide in the $A between 1901 and 2001 reflected a combination of soft commodity prices (which adversely impacted Australia’s terms of trade) and a perception of Australia as a mediocre, inflation prone “old” economy. See next chart.
However, these drivers have now all turned around.
Commodity prices are in a long term upswing, Australia is seen as well managed with inflation under control and interest rates are relatively high, in part reflecting a potentially higher return on capital. In fact, back in the early 1950s when Australia’s terms of trade (the ratio of export prices to import prices) was around current high levels, the equivalent of one Australian dollar bought $US1.12.
In short, it is likely the sub-parity period from the 1980s was the aberration for the $A, and the improvement in Australia’s relative fundamentals suggest it is likely the $A is going to settle above parity against the $US.
Forecasting currency levels is an impossible task but I would suggest an average around $US1.10 is likely in the years ahead, unless the global economy collapses anew.
The impact of a rising $A on the economy and shares
The strong $A is great news for Australian consumers as it will result in lower prices for imported items.
Imports account for nearly 30% of consumption goods, notably things like cars, clothing, petrol and many electrical goods.
This in turn is likely to take pressure off inflation and reduce the extent to which the RBA will raise interest rates.
For the broader economy and shares, a strong $A is often seen as bad news as export and import competing companies become less competitive.
It’s much easier to identify companies that will lose from a rising $A via the impact on their earnings (such as resource stocks, multinational industrials, steel makers and various health care stocks) than to identify companies that benefit because of lower import costs (like some retailers and the airlines).
With around 30% of listed company earnings sourced overseas, a 10% rise in the $A will mechanically cut earnings by about 3%.
This would suggest a rising $A is bad the Australian share market.
However, the problem with
