Download The Australian Dollar - Expect modest weakness

The Australian Dollar: Expect modest weakness
Global Asset Allocation Team – March 2016
Prepared by Aon Hewitt
Retirement and Investment
More weakness ahead for the Australian dollar
The View
Despite already big falls, we believe that the Australian dollar has slightly
further to fall against the US dollar over the medium term. Underpinning
this is a view that monetary policy in Australia will become more
accommodative at a time when the US Federal Reserve will be raising
rates, albeit very gradually. Monetary policy divergence is less obvious
against the Eurozone where further easing is also likely. However, we
believe that there is a risk that the yen could fall against the Aussie on the
view that Japan will extend its ultra-easy monetary policy further.
Recent strength in the Australian dollar, on the back of stronger GDP
growth and commodity prices, is unlikely to last and does not materially
impact the medium-term view.
Action: Under-hedge foreign currency exposure
Equity portfolios should benefit from being under-hedged on foreign
currency exposure as unhedged US equities should outperform hedged
US equities. Yen weakness will only detract mildly from returns given the
smaller weight of Japanese stocks in global equity portfolios.
Risks
Driver
Impact on AUD
Growth
We expect growth to underperform
potential relative to the US
Inflation
Inflation is low affording the RBA flexibility
over monetary policy
Monetary
Policy
Current
Account
Commodities
Valuation
We expect the RBA to ease monetary
policy further to spur economic growth
The current account deficit should expand
on lower commodity prices
Commodities are bottoming, but there is no
big rebound expected
Valuations look fair and in line with both
historic averages and PPP
We expect a small bounce in commodity prices, which is unlikely to
provide a clear boost to the Australian dollar. A stronger than expected
Traders are neutrally positioned in the
commodity bounce is an obvious risk to our expectation. The resultant rise
Sentiment AUD, implying a view of more two-sided
risks at this time
in inflation would also make the central bank less comfortable with cutting
rates, pushing the currency still higher. A big rebound in commodities still
looks unlikely to us as an unlikely scenario.
Key:
positive
neutral
negative
Aon Hewitt | Retirement and Investment
11 March 2016
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The Australian dollar is approaching a 10-year low

The Australian dollar appreciated substantially from 2000 to
2011 for three key reasons:
– Commodity prices were rising rapidly as Chinese demand
for raw materials grew strongly


The Australian dollar's rise and fall
90
80
– Higher real interest rates in Australia than in the majority of
other developed markets, drawing in foreign capital looking
for yield
70
– The currency was significantly undervalued at the outset,
allowing room for significant appreciation (see slide 7)
50
However, all three of these drivers have at least partly gone into
reverse over the last five years, bringing the Australian dollar
back down.
AUD stronger
60
40
1996
2000
2004
2008
Trade-weighted AUD
Source: Datastream
Irrespective of whether looking at the Australian dollar against
the US dollar or on a trade-weighted basis, the Australian dollar
is now hovering close to ten year lows.
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11 March 2016
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1.2
1.1
1
0.9
0.8
0.7
0.6
0.5
0.4
3
2012
USD/AUD (RHS)
Australian growth has been decelerating, but well clear of recession



Australian economic growth has slowed (see top chart), but has
actually held up remarkably well when compared to other major
economies. The economy didn’t fall into recession when most of
the remainder of developed economies did. Although lower
commodity prices have recently dented exports, domestic
consumption remains strong.
However, economic prosperity came at the cost of an
uncompetitive exchange rate. In response to the strong
Australian dollar, the Reserve Bank of Australia (RBA) cut its
main policy interest rate ten times over the last five years (see
bottom chart). This has been encouraged by subdued
inflationary pressures. Throughout most of the rate cutting cycle,
the ‘real’ RBA policy rate has been above zero. Inflation is still
low enough to allow the RBA to continue cutting rates without
taking any risks with creating an inflationary spike.
This means that the bank can ease further, but will they? The
economy has shown its ability to absorb deterioration in its terms
of trade over the short term. However, our view is that current
low commodity prices are here to stay. Short term relief might
come, but the highs seen in commodity prices in the early 2010s
may only be seen again a long way into the future. This means
that the potential growth rate of the economy has fallen, and that
the RBA is likely to be forced to lower interest rates again over
the medium-term.
Australian real GDP growth has been steadily decelerating, but
is still safely positive
6%
5%
4%
3%
2%
1%
0%
1996
Source: Datastream
2000
2004
2008
2012
Australian Real GDP Growth (yoy)
3-year moving average
The RBA has lowered rates 10 times in a row, aiding
currency competitiveness
5.0%
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
2011
2012
2013
2014
2015
RBA cash rate target
Trade weighted Australian dollar (2011 = 100)
Source: Datastream
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11 March 2016
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4
110
105
100
95
90
85
80
75
Bond yield differentials support the US dollar



Currency markets are poised for rising US interest rates and
rates staying low almost everywhere else. This is what drove the
US dollar’s meteoric rise through 2014-15 (see top chart).
However, this means that monetary policy divergence is already
priced in to the strong US dollar, to an extent. Markets also
expect the RBA to ease rates further this year.
While we agree with the market’s view on where Australian rates
are heading, we believe US rates will rise slightly faster than
market pricing implies. This would drive a narrowing in the yield
gap between US and Australian government bonds beyond what
is priced in, and is supportive of the US dollar.
Versus the yen and euro, things are different. Real 10-year
yields are much higher in Australia and the Eurozone than in
Japan. This is clearly not priced in to currency markets as the
yen has actually strengthened against both the Australian dollar
and euro over the last two years. This means that bond yields
imply little in terms of where we can expect the AUD/EUR rate to
head, but they also suggest that the yen will come under
pressure as yield-seeking investors move funds out of the
Japanese market.
Lower relative Australian rates has accompanied a weaker
Australian dollar
3.0%
1.2
2.5%
1.1
2.0%
1
1.5%
0.9
1.0%
0.8
0.5%
0.7
AUD stronger
0.0%
0.6
2005
2007
2009
2011
2013
2015
10yr yield differential: Australia - US
USD/AUD (RHS)
Source: Datastream, Aon Hewitt
Real 10-year rates are similar for Australia and the Eurozone, but
much lower in Japan
0.5%
0.0%
-0.5%
Japan
Eurozone
Australia*
US
*Calculated as 10-year nominal yield less consensus inflation expectations for 2016-2017
Sources: Datastream, Bloomberg, Consensus Economics, Aon Hewitt
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11 March 2016
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5
Slowing Chinese growth have taken commodity prices down



Our view is that commodities will not provide meaningful support
to the Australian dollar over the medium term. Underpinning this
view is our outlook on commodities. Given the tepid global
growth outlook, in particular China’s economic transition (see top
chart), we have to turn to supply for any fundamental factors that
might support prices. Unfortunately, over-supply still plagues
many commodity markets, with iron ore, Australia’s main
individual export (accounting for 26% of Australian exports in
2013), as no exception. Furthermore, with producers becoming
ever more efficient in squeezing down production costs, the glut
shows little sign of ending.
How sensitive actually is the Australian dollar to commodities?
The Australian trade weighted dollar has a historical correlation
of roughly 0.5 with the Bloomberg Industrial Metals Commodity
Index (see bottom chart). However, this correlation has been
rising over time, with the rolling 2-year correlation between the
two price indices at 0.7 now.
Our commodity outlook is not all doom and gloom. We do see
some relief coming from current very low levels. However, we
expect rises to be modest when compared against with the huge
falls seen earlier.
Slowing Chinese growth has contributed to a deep commodity
devaluation
20
600
500
15
400
10
300
200
5
0
2000
100
0
2002
Source: Datastream
2004 2006 2008 2010 2012 2014
China real GDP growth
Bloomberg Commodity Spot Index (RHS)
Commodities and the AUD have moved together
90
300
80
250
70
200
60
150
100
50
40
1990
50
0
1994
1998
2002
2006
2010
2014
Trade weighted Australian dollar
Bloomberg Industrial Metals Commodity Spot Index
Source: Datastream
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6
The Australian dollar is closer to fair value

The Australian dollar shot up in tandem with the commodity
supercycle. This brought the currency substantially above
purchasing power parity (PPP) against its peers. However,
recent weakness has brought the currency back down and much
closer to PPP (see top chart).

Additionally, Australia’s real effective exchange rate1 is at its long
term average.

At this time, valuations are not throwing off any strong signals on
the likely course for the currency.
AUD premia to PPP (OECD) have come down
80%
60%
40%
AUD expensive
20%
0%
-20%
-40%
-60%
1975
1980
1985 1990 1995 2000 2005 2010
vs EUR
vs JPY
vs USD
2015
Source: Datastream, Aon Hewitt, OECD
The Australian Real Effective Exchange Rate (REER) is in line
with its long-term median
120
110
100
90
80
70
60
1972 1977 1982 1987 1992 1997 2002 2007 2012
REER
Long-term median
1REER
is a weighted average of a country’s currency against a basket of other
currencies, weighted by trade volume and adjusted for inflation
Source: Datastream
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11 March 2016
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7
Flows remain a headwind for the Australian dollar but negative sentiment might
be turning a corner


Currency flows, in the form of the current account balance,
indicate further Australian dollar depreciation. Australia’s current
account deficit has already started to reflect the reduced value of
its commodity exports (see top chart). A wide current account
deficit didn’t correspond with a weakening currency between
2002 and 2008, but this time is different. The 2002-08 period
was one of economic strength and of both imports and exports
rising in tandem.
In contrast, today’s deficit is one caused by falling exports and
steady imports; the offset of strong economic growth is not
present this time, which will put downward pressure on the
Australian dollar.
However, the sentiment picture is not so negative. Data
published by the Commodity Futures Trading Commission show
that trader positioning in the currency has just turned neutral in
net terms as short positions have been unwound. This could
signal the end of the recent period of substantial negative
momentum and that the currency might exhibit more of a
sideways pattern from here.
The current account deficit has already started to worsen
0
AUD millions

-5,000
-10,000
-15,000
-20,000
-25,000
2011
2012
2013
2014
2015
Australia current account balance
Source: Datastream
Sentiment is no longer negative
1.2
150,000
1.1
100,000
1
50,000
0.9
0
0.8
-50,000
0.7
0.6
2012
USD/AUD
-100,000
2013
2014
2015
2016
Net Long "non-commercial" positioning (RHS)
Sources: CTFC, Datastream
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11 March 2016
Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority.
2016
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Contact details
Josh Cooper
T: +44 (0)207 086 9768
[email protected]
Sean Marteene
T: +61 2 9253 7282
[email protected]
Aon Hewitt | Retirement and Investment
11 March 2016
Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority.
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Aon Hewitt | Retirement and Investment
11 March 2016
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