Piers Bolger examines the rise of the Australian dollar and its impact on investment decisions.
The Australian dollar (AUD) continues to remain above parity with the US dollar (USD) and is at multi-year highs against other major currencies such as the euro and GBP – levels not seen since it was first floated back in December 1983.
However, the appreciation of the Aussie currency has not been uniform, with the AUD actually declining against the Japanese Yen (JPY) in recent years, highlighting the volatile nature of currency markets.
Therefore, for many investors, whether dealing with a rising or falling currency, the need to consider the impact that the movement in the AUD can have both on investment returns as well as the strategic investment process remains an important element of effective portfolio management.
As Table 1 highlights, the AUD has moved significantly over the last three-year period across all major currencies.
However, while the recent upward move in the AUD has caused a degree of consternation for investors since the floating of the dollar back in December 1983, its performance has indeed been quite variable, and its recent ‘strength’ has not always been the norm.
To highlight this point, Figure 1 shows the ‘value’ of the AUD (as a $100 investment) since December 1983.
As you can see, the performance of the AUD has indeed been mixed, with an extended period of underperformance relative to other major currencies through the 1990s.
During this period, global investment returns were actually higher for Australian investors, benefitting from both the return of investing in rising global markets as well as the translation impact of converting global investments back into AUD returns.
It has only been in more recent years that the AUD has moved higher.
However, it is a trend that we expect will be maintained for some time given the current global environment.
Given the extent of the slowdown in the global economy since 2008, for many investors the question is: ‘What has caused this sudden reversal of the AUD’?
In our view there are a number of factors that can provide some explanation as to the rise in the AUD.
Some of these are fundamentally driven, such as the relative stronger economic outlook for Australia, while others have been more technical in nature (i.e, the interest rate differentials between Australia and the rest of the world):
- Despite both the global and domestic economic slowdown, the Australian economy continues to grow faster than the rest of the world, and has not suffered to the same extent as other developed markets through the global financial crisis and the painful recovery process. This has resulted in Australia benefitting as a place to invest for both domestic and offshore investors, resulting in an increased demand for the AUD.
- Australia continues to have higher relative interest rates compared to the rest of the world. As Table 2 below shows, both the cash rate and 10-year bond yield in Australia is higher than other economies, which makes it attractive for investors seeking ‘yield’ in regard to their investments.
- The ongoing demand for Australia’s mineral and energy resources (i.e, coal, iron ore, gas, etc.) continues at a strong pace. While these investments are traded in USD, the by-product of the resources demand assists in the ongoing demand for the AUD and its appreciation.
- The demand for real assets (i.e, gold) by global investors has also resulted in the USD falling, and by default the AUD has appreciated against the USD. There is a strong inverse relationship between the price of gold and the movement in the USD. As concerns about the ongoing stability of the USD as the global reserve currency continue, this has directly benefited real assets such as gold, as well as other commodities.
- The lack of demand for the USD on a global basis has seen the USD depreciate not only against the AUD but other currencies. With US cash rates close to zero (at 0.25 per cent), and the US Federal Reserve continuing to ensure a high level of monetary liquidity in the economy via its quantitative easing (QE) and other programs, this has led to the ongoing decline of the USD, despite the ongoing financial instability across Europe.
Given there are a number of factors that are contributing to the ongoing rise of the AUD, the question remains: what does the higher AUD mean for investors, and how should they seek to manage their AUD exposure within their investment portfolios?
Firstly, it’s important to note that when making any decision to invest in offshore markets, there will be a ‘currency impact’ on the return from that investment.
That is irrespective as to whether an investor seeks to either increase (i.e, buy AUD) or decrease (i.e, sell the AUD) the amount of AUD exposure they have within the investment portfolio.
This is due to the fact that when investing in global markets an investor receives two components to their investment return: the return generated from the underlying investment, and the return generated from the movement in the AUD against that foreign currency.
Even if an investor seeks to ‘fully hedge’ their investment (via having 100 per cent of their offshore exposure in AUD), it does not mean that the return to the investor may not result in a lower return compared to if the investor had remained unhedged.
What hedging does is ‘lock in’ the foreign exchange (FX) rate at which the returns generated from the offshore investments will be converted back into AUD.
As Table 3 highlights, the movement of the AUD over the investment period and the extent to which an investor is either hedged or unhedged will impact on the total return irrespective of whether the investment decision was good or bad.
As we can see from the performance of global equity markets over the last one-to-five years to 31 December 2011, the performance of the hedged global equity market has been superior to that of investing in unhedged global equities, particularly over the last three-year period, where the relative outperformance has been a staggering 14.6 per cent.
However, it is important to note that, just like any investment, currencies do not always move in a predictable manner, and therefore hedging (i.e, increasing AUD exposure) does not always result in such recent (positive) performance returns.
In this context it is important to consider what ‘exposure’ to AUD is appropriate within a portfolio context, and either being fully hedged or unhedged is too simplistic an approach to managing currency risk in a diversified portfolio.
So with the AUD having risen strongly over recent years – carrying with it the potential to remain higher for longer – there are a number of aspects that investors need to consider in relation to investing globally, and how to manage any currency exposure:
- The appreciation of the AUD has made offshore investments ‘cheaper’. Investors can now get increased asset exposure due the AUD ‘buying’ more of the foreign currency. The benefit is that investors need to invest less to get the same security exposure outcome. This allows investors the ability to better allocate capital within their portfolios and provides the opportunity to consider other investments. By taking advantage of this buying power investors have the ability to make substantive gains should the AUD depreciate from its current levels. While we currently believe that the AUD is overvalued at this point in the cycle relative to our secular forecasts against the major developed market currencies, for those investors who are considering global investments, to do so when the AUD is high against other foreign currencies is logical.
- Secondly, despite the appreciation of the AUD, investors still need to consider whether they have some level of AUD exposure (hedge ratio) in regard to global investments.
We continue to believe that, when investing globally, a level of AUD exposure is important for two key reasons. First, it provides diversification benefits and second, it can lead to reduced portfolio volatility. In a ‘normal’ market environment we view an overall portfolio hedge ratio of 0.3 to 0.4 to be appropriate. - However, for certain asset classes such as global bonds, a fully hedged exposure is more appropriate. This is due to the fact that these types of investments are generally less volatile in nature; and because these investments are fully hedged, investors can benefit not only from security selection but also the positive aspects of the ‘carry trade’ effect on the total return.
Overall, the impact that currency returns can have on the performance of an investment portfolio can be quite profound.
While the AUD has appreciated significantly in recent periods, it does not mean that we are experiencing a complete structural change in its relationship with other currencies, and that recent moves will persist to become the new ‘normal’.
We continue to believe that currency needs to be treated just like any other asset class, and currency management is an important element of constructing and maintaining a diversified investment portfolio.
To this extent, currency exposures need to be ‘managed’, with investors making deliberate decisions akin to any other part of an investment portfolio.
By adopting a proactive approach to currency management when investing in global markets, investors will be better prepared for the impact that currency can have on investment returns and the ability to achieve investment objectives over time.
Piers Bolger is head of research and strategy, advice and private banks, BT Financial Group.
