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The resilient Australian dollar- how long will it last?


The Australian dollar has been surprisingly resilient over the past few months, despite the softening in domestic data and rising US dollar.

 

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.

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:

1. 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.

2. 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.

3. 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.

4. 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 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.

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.

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.

 

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.
Funds related to this article: Dynamic Markets Fund

Navigating the ups and downs of the market cycle. This fund uses dynamic asset allocation to actively adjust the split of investments across asset classes to achieve diversification in response to market changes.

The Fund aims to achieve growth above inflation1 and smooth out the economic cycle over a rolling 5 year basis.

1Consumer Price Index (CPI) - the Reserve Bank of Australia inflation rate, trimmed mean

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