Why the exchange rate matters the most

Not many investors pay attention to exchange rates. Except perhaps when it comes time to spend their money overseas.

But this is an expensive mistake to make.

The power of the forex market is immense. It has a huge influence over your returns, for a start. But it is also a signal about the future that can be useful to investors when deploying their capital.

Let’s take a look at what investors need to keep in mind about exchange rates if they want to succeed, even if they stick to the ASX.

Stocks are slaves to the exchange rate

Not all investors are equally influenced by their currency. In some countries, the exchange rate only plays a small role.

But as currencies go, the Aussie dollar is disproportionately influential to its stock market. It effectively splits the market in half.

There are companies that earn their revenue in foreign currencies and companies that earn Aussie dollars.

When the Aussie dollar is rising, it disadvantages the companies earning foreign currencies. That’s because their foreign currency profits are worth less in Aussie dollar terms.

When the Aussie dollar is falling, it increases the value of foreign currency profits. So a falling currency is good for exporters’ share prices.

The inverse goes for companies that import their inputs. But let’s keep things simple.

The point is that our market is split into groups that benefit or lose from currency movements. You need to be in the right camp at the right time, or you’ll be swimming against the tide of exchange rates.

Why is the ASX especially sensitive to the exchange rate? Because it is full of commodity producers that sell their resources in US dollars. So our exchange rate sets the tone for a disproportionately large chunk of the overall market.

During Aussie dollar bear markets, commodity stocks outperform. During Aussie dollar bull markets, they underperform.

But it’s not that simple!

The Aussie dollar is a commodity thief

The exchange rate has a big impact on important parts of the stock market. But the reverse is also true.

The Aussie dollar’s performance is partially driven by our trade balance. So a booming commodity industry can actually cause the Aussie dollar to go up.

Here’s the crucial take away: in that case, the stock market returns from a commodity boom are offset by the rising Aussie dollar.

This means our currency has a nasty habit of undermining our stock market’s best years. Just when our economy is booming and our big export companies are raking in the profits, our currency goes up. This devalues the foreign earnings of our big commodity producers and other exports. Which effectively keeps a lid on the ASX200.

You could say that the Aussie dollar robs Australian investors of their best gains.

Foreigners who bought Aussie stocks are the ones who get their cake and eat it too. They make capital gains and exchange rate gains during a boom.

But it’s not all bad news for us domestic investors.

How to harness our currency’s weakness

The good news is that, during periods of AUD underperformance, foreign assets get a strong tailwind.

This can happen during a crisis. For example, during the global financial crisis, US stocks halved. But for Aussie investors holding the same US stocks, the crash was only half as bad because our currency plunged too. This offset the losses.

During the worst months of 2008, the Aussie dollar actually fell at the same pace as US stocks, fully offsetting the losses!

Getting the Aussie dollar’s direction right can also be the source or outright profits.

Years ago, a friend of mine joined a fund and discovered the secret to their impressive long-term performance. They had owned only foreign stocks when the Aussie dollar was falling and only local ones when it was rising.

So the exchange rate gains were behind the fund’s outperformance, not the stock picking. As he put it, “investing is easy. You just buy foreign stocks and wait for the Aussie dollar to bail you out.”

Our currency is our privilege

American investors have a more complicated relationship with their currency. Its value tends to rally when stock markets and economies are in crisis. This makes investing in foreign assets doubly risky.

If there’s a crash, the Americans investing overseas will lose money on the stocks and the exchange rate.

But during a boom, the exchange rate adds leverage to foreign stocks and US exporters like energy companies.

So American investors see their portfolios fluctuate more thanks to exchange rate effects while Australian investors see their portfolios fluctuate less.

The UK is more like Australia. In 2016, it provided a fantastic example of how powerful the exchange rate’s effect can be on stocks.

Economists predicted an economic and financial meltdown should the people vote for Brexit. Instead, the UK stock market soared and foreign direct investment into the UK soon hit a record high.

Why?

The exchange rate. The pound tumbled. This enticed investors into the UK. And made the foreign earnings of UK listed companies worth more in local terms. A real tailwind for stocks.

Of course it was a dodgy one, in a way. Devalued exchange rates might bid up some segments of stock markets, but not all. And local investors will notice the hidden cost when they go overseas.

But even then, all this is impressive proof of the importance of exchange rates.

Currencies predict the future

A big debate in finance is whether currencies anticipate the future or react to economic reality.

In practice, it’s a bit of both. So, when a currency is soaring or plunging an inexplicable amount, you need to pay attention. It is telling you that something important is about to happen.

The recent action in the yen is a good example of this. It demonstrates why exchange rates matter so much as an indicator. The Japanese economy and financial system are in trouble.

Since the end of the gold standard, exchange rates have been a pressure valve and canary in the coalmine. Countless governments have been humiliated by the need to devalue their currency after poor policies crashed the economy.

In the age of floating exchange rates, currency values are practically a measure of political credibility. If your currency is crashing, you know the government will need to do something different soon.

In the past, inflation was the pressure valve. Poor economic policy resulted in the value of your money falling domestically.

But global trade has limited inflation’s ability to break out. And so now it’s exchange rates that give the game away instead.

What are they telling you right now?

Well, for as long as I can remember, the trader Murray Dawes has kept one eye on the currency markets to answer that question. Not just because he runs our only service focused on foreign stocks.

Each morning he peruses the key currency pairs that are a proxy for risk, carry trade flows and political instability to try and anticipate what happens next in financial markets.

If you’d like to know what his analysis is telling you each week, you should take a look at Murray’s work here.