We have taken the view that attempting to predict the near-term direction of currencies, particularly for long-term investors, is extremely difficult.
In our diversified funds, around half of our overseas growth asset exposure is hedged back to the Australian dollar, with the remainder unhedged. Naturally, hedged global equities have performed considerably better over the past year than unhedged, given the strength in the $A, but that has not always been, and will not always be the case.
Nevertheless, we do have the ability to adjust the proportion of hedged vs unhedged exposure in our funds from time to time, and have recently done so – reducing our hedged global equity exposure in favour of unhedged.
One of the key factors behind the decision is valuation. Against the US dollar, the $A is trading significantly higher than purchasing power parity (PPP) estimates of fair value – around US93c against a fair value in the high-60s. Over time, the A$ has tended to trade around PPP estimates, such as those published by the OECD, but deviations from fair value can persist for some time.
Perhaps the best way to think about the A$ now is a balance of risks approach. If I am prepared to buy the $A at US93c, how right could I be? The currency has momentum behind it, and we could easily see a test of parity with the US$. However, a substantial move beyond that level would, in our view, be difficult to maintain. On the other hand, if I decide to buy the $A at US93c and I get that wrong, how wrong could I be? History suggests I could be US30c (or more) wrong. I have no idea where the currency is heading in the next month or even the six months or twelve months. However, we get paid to make judgements about asset allocation with a medium to longer term view in mind. On this score, it’s hard to see the $A remaining at or higher than current levels over the medium to longer term.
Of course, there are some very good reasons to be positive about the currency. The Australian economy’s exposure to what will arguably be the fastest growing region of the world over the next decade or more is one reason to believe that maybe we could sustain a higher $A. Working against that however, is the likelihood that PPP estimates are likely to move lower over time, as Australia’s inflation rate remains higher than that of other developed economies.
Another reason for optimism is related to the aggressive monetary response by the US authorities to the crisis, in particular the aggressive injections of US$ liquidity into the financial system and outright purchases of US Treasury securities by the Fed which effectively amount to ‘printing money’. There is a concern that such efforts will diminish the role of US$ as a reserve currency, produce higher inflation and debase the currency.
While these concerns have validity, the US authorities are not alone in taking extraordinary steps to rescue their economy and financial system. In other words, if I want to sell the $US, what am I going to buy? Swiss Francs? Yen? Sterling?! Even the European Central Bank has recently got in on the act with its measures to help finance the Irish Governments’ bail-out of its financial system. The solution for traders seems to have been to buy a) gold and b) currencies where the authorities are NOT debasing the currency.
The list is short, but includes Australia, Canada, and NZ.
On balance, we certainly are prepared to accept that the $A could sustain higher levels against the $US and other currencies over time – just not as high as those we are currently seeing.
Brian Parker is investment strategist for MLC