While the Australian dollar started 2016 weaker, strong iron ore prices have driven it sharply higher. We discuss why we believe the currency will fall, and how investors can embrace currency volatility to stabilise their portfolios
Volatility in global markets is certainly the theme for 2016. Global equity indices have fallen as much as 10% before recovering to just a 4% drop. Commodities and currencies have been equally as volatile. And while the price changes in bonds were far less than the other markets, prices have still risen quite sharply and then given back half their gains.
For the Australian dollar (AUD), the start to 2016 has been just as volatile. Concerns about China saw the AUD fall to $0.6830 against the USD before negative Japanese interest rates and then strong iron ore prices saw it rise sharply to a high last night of $0.7472.
We maintain our fair value range for the AUD/USD as $0.65 to $0.70, as we have for the past 18 months. In that time, markets have fluctuated through a remarkable range and the volatility if anything is rising, not falling. But the fundamental drivers of this fair value estimate remain the same.
The three long term fundamentals that will push the AUD lower
1. China’s industrial sector has slowed dramatically, pushing down iron ore prices in particular.
Long term trend
China has a two speed economy. While the consumer and services sector is growing at around 10% per annum, industrial growth, making up 45% of the economy, is growing at less than 1%pa. Official data might suggest faster growth, but using more reliable sources of data such as electricity output, import and export volumes and freight demand, growth is 0-1%pa at best. The industrial sector, including construction of buildings and infrastructure, was the driver of the Australian mining sector boom and high commodity prices, and so the slowing of that sector means lower prices for iron ore and the AUD.
Recent market movements
The surge in iron ore prices in the past week appears to be due to the promise of government spending rather than any actual demand increases. Recent comments by the Chinese government that they will continue to invest in development, reinforced by the Chinese Premier Li Keqiang on Tuesday saying that ‘fortune requires building’, resulted in Chinese steel prices rising more than 20% in two days and global iron ore prices following suite. But the Chinese government’s own work report showed spending on infrastructure would only rise by 4.7% this year, and railway investment at all levels of government (infrastructure spending is the result of central Chinese government as well as local and provincial government spending) would be flat year on year. These comments resulted in Chinese steel traders stocking up, but inventories can’t grow forever, so unless demand grows, prices will settle lower in the coming weeks.
2. The Australian economy needs a lower dollar – RBA will not sit on the sidelines.
Long term trend
The Australian economy needed a hero to save us from the sudden demise of the mining investment boom. That hero came in the form of the construction sector, fuelled by demand for investment property. The surge in demand for new apartments has resulted in a 25% increase in apartment settlements expected in 2016 compared to last year, up from 36,486 to 44,784. This is expected to peak at 52,920 in 2017. But at this pace of growth, undersupply is shifting very quickly to oversupply, particularly in Brisbane and Melbourne. Signs of a slowing in new projects are now showing with construction sector wage growth, a useful lead indicator of new construction work, already at a 20 year low and falling.
Recent market movements
GDP growth data out last week showed the Australian economy growing at 3.0% for 2015. This is a good result, but the market overreacted to the headlines. GDP data is volatile, subject to revision and backward looking. We prefer to look at lead indicators such as wage growth (an economy growing strongly will demand more workers, which in turn pushes up wages) and confidence. Wage growth in Australia is very low, in fact at its lowest since records began in 1998. Mining, construction and professional services are all well below 2%pa growth and falling.
The two sectors of the economy that have shown recent growth are tourism and education, both reliant on a lower AUD for competitiveness. With mining investment and now construction past their peaks, the RBA will not sit on the sidelines at let the AUD rise and threaten these sectors.
3. Currency wars and a chronically weak Europe and Japan mean global interest rates lower for longer
Long term trend
Europe and Japan will have near zero interest rates for the next 5-10 years, if not longer, due to their inescapable challenges from an aging and now declining population and high fiscal debt. This will force China to hold rates lower in order to boost its economic competitiveness, as we have seen recently with their attempts to devalue the Renminbi. US economic growth is now almost strong enough to justify a small increase in rates, but with the three next biggest economies all heading in the other direction, any increase in rates in the US will push the USD even higher, threatening the its recovery. So the US central bank (the Fed) will also be holding rates lower for longer.
Recent market movements
Since the beginning of 2016, global financial markets have finally realised that economic growth is weak globally, and that no matter how much QE and cheap debt is applied, we are now in a phase of lower economic growth. Market reactions to this have been to sell equities, buy bonds, sell commodities and shift currency holdings into higher yield currencies, like the AUD. This presupposes that the RBA will not lower rates, or even might increase rates, meaning anyone parking their cash in Australia will get a better rate of interest. We believe that this assumption is flawed and that with a small comment or two from the RBA about currency, markets will reverse these positions.
Strategy
The AUD is fundamentally valued at $0.65-$0.70 based on the prospects for the Chinese economy, world growth and our own economic prospects. Long term interest rates in Australia similarly, should reflect a lower interest rate outlook than they currently do. The currently high price for the AUD and high yields on offer will not last long in the face of any weak economic news for Australia or globally, which we believe is a likely scenario within the next few weeks.
One of the most powerful strategies in the current environment is to pick up the USD or GBP denominated corporate bonds of the world’s largest resource companies, particularly those with Australian operations. This strategy provides some strong hedges in times of volatility, while offering a stable yield. The hedge comes from the fact that if commodity prices fall, the AUD tends to fall, particularly from its current peak levels. This means that while the price of the bond in USD might fall slightly (more for higher risk resource companies, less for the global majors with large surplus cashflows like BHP), this should be more than offset by the rise in the value of the bond when brought back into AUD. The commodity and currency prices moving in opposite directions create a hedge, and in the meantime investors receive reliable income and capital stability, relative to equity markets.
Buyers of Fortescue Metals Group and BHP bonds have experienced much lower volatility than the share prices of the same companies as an example. Similarly, the income from BHP bonds is an obligation of the global giant, whereas their “progressive dividend policy” proved to be more promise than obligation, as is always the case with dividends.
Holders of Fortescue bonds have seen strong gains recently and, with Fortescue ranked amongst the second tier, not top tier miners, this could be a strong opportunity to switch from Fortescue positions into larger more diversified resource companies like BHP or Glencore.