- Despite the current strength in the Australian dollar ($A), we still see the $A heading lower during the coming year because recent commodity price gains are unlikely to be sustained at the same pace, the US dollar is expected to continue rising and there is still the risk that the Reserve Bank of Australia (RBA) cuts the cash rate again.
- The RBA wants a lower currency to assist non-mining growth. A high exchange rate reduces GDP growth during the medium term but the impact across industries is quite varied.
- The most direct impact of currency changes are on industry exports. The RBA estimates that the most significant negative impacts of an appreciation in the currency affect mining, manufacturing and other business services.
- Business surveys suggest that Australian firms are now better placed to deal with a higher $A than a few years ago perhaps from all the years of dealing with a strong currency.
- A lower $A will be helpful in further assisting a recovery in non-mining business investment. But, if businesses are now better able to deal with a higher $A, then perhaps a smaller-than-expected currency depreciation would still generate the necessary positive growth impulse the RBA wants to see.
The Australian dollar ($A) has been resilient during the second half of 2016 because commodity prices rallied, the Fed pushed back interest rate hikes, the market started pricing out interest rate cuts from the Reserve Bank of Australia (RBA) and Australian (and global) data generally held up. The RBA would be more comfortable with a currency below 0.7USD to assist the currency-sensitive sectors of the economy as mining investment continues to unwind and remains a drag on growth.
The US dollar ($US) has increased significantly during the past month (+3%) as markets brace for “Trumponomics” which is anticipated to include high fiscal spending, corporate and personal tax cuts, trade tariffs and an increase in government debt, which should lift US GDP growth during the near term as well as increase inflation, leading the Federal Reserve to increase the Fed Funds rate faster than previously expected. The $US is now at a two-year high but despite this strength in the currency, the $A has been (surprisingly) resilient because commodity prices have been holding up.
Source: Reuters, AMP Capital
Despite the recent strength in the domestic currency, we still see the $A heading down to below 0.7USD during the next year or so because i) recent commodity price gains are not likely to continue ii) Fed rate hikes will lift the $US and iii) there is still the risk of another RBA interest rate cut, which the market is not currently pricing. We think that inflation will take longer to get back to the RBA’s 2-3% target band than current forecasts assume, particularly because of spare capacity in the labour market (evidenced by very low wages growth). Coupled with softer domestic data recently and a slowing in dwelling prices, this will give the RBA the room it needs to cut interest rates during the first half of 2017.
Industry impacts of a high currency
Economic theory states that a higher exchange rate is a negative for the economy because a country’s exports become more expensive on the global market, causing export volumes to fall. The negative business impact is assumed to offset the positive consumer impact of cheaper imported goods. A depreciation in the currency has the opposite effect of dropping the price of a country’s exports on the global marketplace, lifting export volumes. Consumers tend to be worse off with a lower currency because imported goods prices rise. Consumers also tend to view a high $A as a positive sign of economic strength or global resilience (whilst also benefitting from cheaper goods and holidays, which increases disposable income).
The RBA published a research paper measuring the quantitative impacts of a currency appreciation on the economy. The RBA estimated that a 10% appreciation in the exchange rate will result in a 0.3 percentage point reduction in GDP about 18 months from the time of the initial appreciation. But, this broad outcome masks differences across industries because currency changes impact businesses and industries through numerous channels (and often in competing ways) including:
- The impact on exports, which is a direct influence on production. 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 good lifts on the global market, switching demand to the competition,
- The impact on imported goods prices if they are used as an input in an industry’s production. An appreciating (depreciating) $A will lead to lower (higher) input prices, benefitting (detracting from) margins,
- The impact of a change in imported competition. A higher currency lowers the price of imported goods. If an industry has a high degree of imported competition, they could be negatively impacted if competitors drop their prices and they have to follow, leading to potential margin pressure,
- The impact from the indirect channel of businesses supplying goods/services to other industries, which are initially and more directly affected by exchange rate movements.
The RBA found that industries which are most (negatively) affected by a higher currency are mining, manufacturing and other business services.
Mining and manufacturing are most affected through the trade channel. The manufacturing industry has a high share of imported goods parts, which lowers costs for businesses, but the drop in exports more than offsets lower input prices.
Business services are impacted from a higher currency through the indirect impact of supplying other industries, which are directly influenced by the currency.
What do the business surveys tell us?
The National Australia Bank (NAB) has been surveying businesses about the impact of currency changes on business activity since mid-2014. During that time, the proportion of businesses that reported being negatively affected by the level of the $A has declined (from 32.5% to 28%), which makes sense because the $A has depreciated by 19% since mid-2014. But, at some points during this period, despite a depreciating $A, the proportion of businesses that reported being negatively affected by the level of the currency increased. And most recently, the appreciation in the currency (since end 2015) has been matched by a noticeable reduction in businesses reporting being negatively impacted by the level of the $A, which could be a sign that businesses are finding the correct business strategies to combat a high currency.
Source: NAB, Reuters, AMP Capital
How do businesses combat exchange rate movements?
The key strategy that businesses report to deal with exchange rate movements is hedging currency exposures and also refocussing business to the domestic market, rather than through downsizing (which was much more utilised in mid-2014 when the currency was much higher).
Source: NAB, AMP Capital
Implications for investors
A lower $A will be helpful in further assisting a recovery in non-mining business investment. The depreciation in the $A during the past two years has been a big beneficiary to service exports particularly 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.
Source: ABS, AMP Capital
But, if businesses are indeed now better equipped to deal with a higher $A, then perhaps 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 0.7US during the next year particularly now when there is more upside pressure on the $US as markets factor in more Fed Fund rate hikes in 2017. Against this backdrop, it makes sense for investors to maintain a decent exposure to unhedged global assets as these will rise in value if the $A falls.
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