Diversification: the best defence against a falling Aussie

Clearly, that Isaac Newton bloke was on to something. Particularly when it came to that “third law of motion” that he managed to rustle up while cogitating under an apple tree.

And any investors who have been tracking the movement of the Australian dollar of late have no doubt arrived at the same conclusion as one of history’s most renowned physicists, with the local currency having fallen more than 9 per cent against its US counterpart in the year to date.

The Aussie, which began the year at 78 US cents and briefly topped 81 US cents in late January, was at 70.67 US cents as at Friday, 5 October.

But while a falling Aussie, and conversely, a strengthening greenback, can be met with open arms by the likes of locally based export companies, for many advisers and their clients it can cause a great deal of pain and anguish.

However, there is a way to ameliorate some of the adverse effects that a falling Aussie can have on a portfolio. And while it may almost be a cliché in the world of investing, repeating the mantra of diversification can end up sparing investors from many a sleepless night.

According to BetaShares chief economist, David Bassanese, maintaining a passive exposure to a diversified basket of currencies can be an effective source of portfolio protection.

“Predicting currency movements is a difficult task, one that even the experts struggle to get right consistently. Global currency markets are very efficient – market sentiment, macroeconomic and political factors all play a role and can impact currency movements in a very short space of time,” he says.

“Therefore, we would suggest maintaining a passive exposure to a diversified basket of currencies. Investors usually obtain such exposures by maintaining a well-diversified portfolio that includes global equities.

“This is one of the key attractions of ETFs (exchange-traded funds) in that they can cost effectively and conveniently provide investors with very well-diversified exposures.”

Bassanese also points out that the Aussie tends to be correlated with the global business cycle, and therefore, by maintaining an unhedged position, it assists with dampening return volatility during times when the global equity markets sell off.

“In other words when global equities fall, the Australian dollar also tends to fall, meaning the unhedged Australian dollar value of the international equities does not fall by as much (and vice versa),” he says.

“However, as with any asset there are occasions when valuations can appear to be extreme, such as when the Australian dollar was trading at parity with the US dollar. In such instances an active currency decision can make sense.

“Investors can easily access pure foreign currency exposures by way of a number of currency ETFs which are available on the ASX. We are also seeing many investors use currency ETFs as solutions to maintain their foreign currency exposure when they, due to their view on valuations, sell down foreign equity exposure.”

And when it comes to investors ensuring that they’re not “doubling up” when exposed to certain currencies, or in other words, ensuring they’re not overexposed to a particular currency via a large exposures to a certain stock, Bassanese says investors should “absolutely” know the types of exposures they ultimately face.

“Companies with substantial revenues generated from offshore markets will effectively take on more indirect currency exposure. For well-diversified portfolios these additional risks become less relevant,” he says.

Andre Severino, global head of fixed income at Nikko Asset Management, also emphasises the importance of understanding the main drivers of return for any investment that an investor may undertake.

And understanding how currency exchange rates influence the earnings of a company would certainly fall into this category.

“However, it may not be straightforward to understand as many companies will hedge their foreign currency exposures to lock in an exchange rate over a given time horizon, which can remove currency volatility over the period of the hedge,” he says.

“Other companies will choose not to hedge and assume that over long time periods the exchange rate volatility will equalise. Over the last 10 years the AUD/USD exchange rate has almost remained unchanged. However, during the period the exchange rate traded between 1.10 at 0.62.”

Severino argues that an active approach has its benefits when it comes to currency management. However, he points out that it requires a great amount of systematic analysis in order to perform well.

“There are many factors that influence currency exchange rates, so understanding these factors such as relative economic fundamentals, interest-rate differentials, political factors, central bank influence and market flows, are key to forecasting these movements,” Severino says.

“There are also unforeseen factors such as geopolitical factors that can cause currency volatility, so unless an investor has the resources to monitor all of this closely, they may want to leave currency exposure management to an experienced and qualified portfolio manager.”

WHERE TO NOW FOR THE AUSSIE?

Investors may be wondering where the Aussie dollar is expected to go from here. Bassanese expects the greenback to remain strong over the short to medium term, while also foreseeing some continued downside risk to the Australian dollar.

“Declining iron ore prices, due to China’s clamp down on excess steel production, and a growing negative interest rate differential with the United States, should keep downward pressure on the Australian dollar,” he says.

However, Joseph Capurso, a senior currency strategist at Commonwealth Bank of Australia (CBA), sees the Aussie dollar lifting a little bit next year.

“So, we’ve got it ending 2019 at 75 US cents,” he says, adding that there were a few factors underpinning this forecast.

“Now, the big reason is we think the US dollar will start to ease against most currencies, particularly once the Fed (US Federal Reserve) stops increasing interest rates, which we think will happen around the middle of next year,” he says.

“So, if the US dollar is falling against most currencies, it’s going to fall against the Aussie dollar as well.”

Another reason Capurso sees the Aussie dollar lifting a bit is that CBA expects the Reserve Bank of Australia (RBA) to start raising rates on Melbourne Cup Day in November of next year.

“We think they (rates) will increase by about 1 per cent, from 1.5 per cent to 2.5 per cent.”

But while Carpurso also thinks the rise in the Aussie will be capped by some further falls in commodity prices, given the Chinese economy’s slowdown throughout 2018, he says there is a potential offset to this scenario.

“The Chinese government have announced some budget stimulus measures, focusing mainly on infrastructure from what we can tell. Now, we haven’t seen that happening on the ground yet or in the data but that could well provide some support to commodity prices and the Aussie dollar,” he says.

EYE ON TRUMP AND NEIGHBOUR TO THE NORTH

But Capurso points out that there are caveats to CBA’s forecast for the rise in the local currency in 2019, foremost among these being what happens to the Chinese yuan renminbi. He says the bank’s view on the Chinese currency is that it’s going to depreciate about another 10 per cent between now and the end of next year, in what he describes as “a fairly reasonable depreciation”.

“And that will make it a little bit harder for the Aussie to lift because the Aussie dollar is used as a proxy for Asian currencies, because the Aussie is freely floating unlike some of the Asian countries where the central bank heavily intervenes,” he says.

In the nearer term, Carpurso says that given the ongoing trade frictions between the US and China, he sees the Aussie dollar testing 70 cents before the end of 2018, given the situation is likely to be exacerbated.

While it may seem overly simplistic, Capurso explains the Aussie dollar’s relationship with the US-China trade war as follows: the US is trying to slow down its imports from China, while Australia exports a lot of goods to China.

“So, roughly 30 per cent of Australia’s exports are to China. Now, the way the market looks at it is: Australia is dependent on China; China is dependent on the US,” he says.

“Now, that’s a caricature – and not a particularly accurate caricature – but that’s how the market seems to trade this, and it kind of makes sense in that the Chinese renminbi and other Asian currencies are much less liquid than the Aussie dollar, so the Aussie dollar trades as a proxy for these currencies that are less liquid.

“So, it kind of makes sense – the economic linkages don’t really support it – but given the market structure, it does make sense why the Aussie falls as these US-China trade issues exacerbate.”

Carpurso says CBA has done some detailed economic modelling which shows that of all the goods that Australia sells to China, almost none of it is re-exported to the US.

“Most of what Australia sells to China, stays in China,” he says.

“One example is: we sell iron ore to China, China turns the iron ore, with coal, into steel; and the steel is used to make a railway – not a railway in America.”

Like Carpurso, JP Morgan Asset Management global market strategist, Kerry Craig, says he is thinking about an Australian dollar testing 70 US cents in the near term.

“The spread between US and Australian treasuries has widened out and will probably continue to widen out given the differences in monetary policy,” he says.

“Commodity prices have been holding it (the AUD) up for a while but we expect them to wane a little bit, so we do think commodity prices … should steadily come down as we think about the end of the cycle – we do think about the Australian dollar trading under 70 cents by next year.”

JP Morgan has the Australian dollar at 68 US cents by the middle of next year, and while Craig believes it will definitely go below 70 US cents, he says this is dependent on the commodity price outlook.

“So, if you saw massive stimulus from China – if China just went all in and said, ‘Let’s just throw money at the economy’ – then you have demand, commodity prices and the dollar goes up,” he says.

“But’s that’s not our view.”