In the hierarchy of egos you’ll find battling it out on investment bank trading floors, foreign exchange traders sit at the top. That’s because exchange rates are notoriously hard to predict.
Unfortunately, the exchange rate is half the equation of any investor’s success or failure. And yet, most of us completely ignore it…
You might think that the Aussie dollar’s value on markets plays little role in the size of your super fund. But you’d be so very wrong. All our stocks are impacted, however indirectly it may seem.
Of course there’s the obvious impact, such as on foreign revenues of Aussie companies. The value of the Aussie dollar determines how much their pound, yen and euro income is worth once it’s translated to dividends for ASX shareholders.
Just as importantly, the Aussie dollar shifts how foreigners perceive the value of our stocks. An expensive Australian dollar means Aussie companies are expensive for foreigners to buy. They get less stocks per pound…literally. If the Aussie dollar halves, it’s like having a 50% off sale for foreigners. The same stocks, for the same price on the ASX, but at 50% cheaper in terms of their own currency.
And, with foreign investors a major holder of ASX listed companies, that factor is important. Orient Capital estimated in 2018 that only ‘68% of market capital in the average ASX 200 share register is held by Australian investors.’ So it’s obvious that the exchange rate and its prospects directly affect investors from overseas. But that also means their decisions to buy and sell impact Aussie stocks prices themselves.
Investors should also remember that all prices are ultimately valued in US dollars in order to become globally comparable. When a European pension fund is choosing to invest in Vale or Rio Tinto, they do the maths in comparable terms, meaning adjusted for exchange rates. And so the demand for Aussie stocks is impacted by the exchange rate and its prospects.
So, just because Aussie investors think in terms of Aussie dollars, doesn’t mean that the true price and value of those assets should be measured in Aussie dollars. Investment markets are far too global. In international terms, if you want to know the value of Aussie stocks, you need to convert their price to the global standard — the US dollar. And the exchange rate is half of that equation.
But there are also more subtle ways the Aussie dollar has an impact on our domestic share prices.
Consider that the Aussie dollar is seen as a ‘risk-on currency’. It goes up in value when the global economy and financial markets are performing well, and falls when things are going badly.
This is true for a long list of reasons, many of which also directly impact Aussie share prices. When the economy is booming, people want to own the sorts of shares we have a lot of in Australia — commodities, financials and property. The money piles in, bidding up the currency and the share prices.
Should the prospects of Australia’s mighty mining sector suddenly surge, this implies surging exports. And that bids up the Aussie dollar. But what effect would this have on the value of those stocks in Aussie dollar terms? It means downward pressure because their foreign revenues become worth less in Aussie dollar terms.
Even worse, a rising Aussie dollar during a booming commodity export cycle is bad news for all other Australian exporters. Their foreign revenues fall in Australian dollar terms too. And they probably don’t have a commodity boom to profit from to offset this. And so a high dollar weighs on their share prices too.
Which brings us to why I’m pointing all this out to you. If the Aussie dollar is a risk-on currency, then it is going to put a dampener on any stock market boom that occurs due to an improving global economy.
Instead of our stocks soaring as our companies do well, the Aussie dollar will just go up instead. And this inherently puts a headwind against Aussie stocks’ performance.
Of course, it’s not quite that clear cut. Sometimes our stocks could go up despite the currency rising, such as between 2003 and 2007. And sometimes the rising currency could keep a lid on a boom, as during our disappointing stock market recovery from 2008. But, either way, a rising Aussie dollar is a headwind for a stock market.
Think of it like this: how big would Australia’s stockmarket boom of 2003–2007 have been if the Aussie dollar hadn’t gobbled up much of the gains by rising about 50%? The profits earned by exporting companies in Australia would’ve been much higher, and Aussie stocks would’ve been much cheaper for foreigners to buy, suggesting much higher share prices.
This also means it’s foreign investors that truly benefit from investing in Australia during a boom. They collect the gains on exchange rates and the capital gains too. Aussie investors only collect on the latter.
But the broader thing to realise is that a country’s currency profile has an outsized impact on its stock market returns. And so you can’t afford to ignore them.
In places like the US and Japan, which are perceived as having ‘risk-off currencies,’ it’s the opposite situation to us. During a boom, the US dollar falls and this adds a tailwind to the US stock market. During a bust, the US dollar surges, making returns even more disappointing for local investors.
Of course there are exceptions to these generalisations. And the gains and losses of stocks can offset the currency’s moves. And it’s also worth noting that a high Aussie dollar does benefit Australians in other ways, including overseas holidays.
But for investors, we need to be aware that the exchange rate plays a crucial role in our success. And, assuming you’re investing in the Aussie market to deliver outsized gains during boom times, the nature of the Aussie dollar makes it your worst enemy.
Does that mean you should invest overseas? Well, it depends where — what’s the nature of their currency?
If you invest overseas and the Australian dollar surges, that’s put you at an even further disadvantage. Your capital gains must outperform the exchange rate’s moves.
This is why investing in countries that also have risk-on currencies, but which are less risk sensitive than the Australian dollar, doesn’t make much sense. In a boom, the Aussie dollar is likely to rise faster than the other country’s currency on global markets, creating a headwind for the value of your investments in Aussie dollar terms.
I’d put the UK as an example of this. If we experience a global boom and the FTSE100 rises 20%, but the Australian dollar rises 25% against the pound, you’ve lost 5%…
Investing in the US makes sense as a hedge because, during a bust, the US dollar surges. This means the capital losses of the bust will be offset by a rising US dollar. The Swiss franc and, until recently, the Japanese yen are good examples of this.
Another area to invest that makes sense is in countries with even more sensitive exchange rates than ours. During a boom, their currencies will rise faster than the Aussie dollar, so you’ll have gains in terms of the local stock market prices and the exchange rate too. The Brazilian real, Turkish lira and, until recently, the Russian ruble are good examples of this.
Of course this adds much more risk overall. During a bust you’d lose out on the exchange rate and the share prices.
Foreign exchange traders call a currency’s sensitivity to risk its ‘beta’. The US dollar, Swiss Franc and Japanese yen tend to have a negative beta, meaning they go up in value during bad times. The British pound, Aussie dollar and Canadian dollar have a medium beta — they rise during boom times. The lira, real and ruble surge during a boom and plunge during a bust faster than most.
I think Aussie investors should focus on negative and high beta investments to avoid being robbed by the Aussie dollar during a boom. This allows them to hedge risks and profit from good times.
Before you go, one last thing to mention. I believe that the missed capital gains of Aussie stock market investors are probably a good thing for the overall economy. The Australian dollar doesn’t just reduce your gains during good times. It also acts as a countercyclical stabilising influence on the economy. It prevents booms from getting out of hand and helps us recover during a bust. That’s one reason we didn’t have a recession in 2008 — the Aussie dollar plunged so far that it helped revive the economy.
The same applies to stocks. How bad would the 2008 crash have been if the Aussie dollar hadn’t plunged to help keep companies afloat?
Understanding these impacts and trade-offs is crucial to your overall investment success. Even if they are so broad that you don’t notice them on a day-to-day basis.
Kind Regards,
 |
Nick Hubble,
Editor, Strategic Intelligence Australia
Comments