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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 Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. 2 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. Aon Hewitt | Retirement and Investment 11 March 2016 Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. 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 Aon Hewitt | Retirement and Investment 11 March 2016 Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. 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 Aon Hewitt | Retirement and Investment 11 March 2016 Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. 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 Aon Hewitt | Retirement and Investment 11 March 2016 Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. 350 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 Aon Hewitt | Retirement and Investment 11 March 2016 Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. 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 Aon Hewitt | Retirement and Investment 11 March 2016 Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. 2016 8 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. 9 Aon Hewitt Limited Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Registered in England & Wales No. 4396810 Registered office: The Aon Centre | The Leadenhall Building | 122 Leadenhall Street | London | EC3V 4AN To protect the confidential and proprietary information included in this material, it may not be disclosed or provided to any third parties without the prior written consent of Aon Hewitt Limited. Aon Hewitt Limited does not accept or assume any responsibility for any consequences arising from any person, other than the intended recipient, using or relying on this material. Copyright © 2016 Aon Hewitt Limited. All rights reserved. Aon Hewitt | Retirement and Investment 11 March 2016 Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. 10