Aussie Stocks And The Aussie Dollar

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– The AUD is overvalued against traditional commodity price measures
– The impact of a strong AUD on resource stocks is varied
– The impact of a strong AUD on many ex-resource stocks is more dire
– Confession season may yet bring some upside surprise

 
By Greg Peel

“Fifteen years ago, global commodity prices were determined by US consumption. The stronger the US economy, the higher commodity prices. In the past fifteen years the correlation between US economic growth and commodity prices has declined, notes CBA, and the flipside is the rise in correlation between commodity prices and Asian economic growth, to the point where now the two follow in an almost one-for-one trend.”

– Aussie Dollar: Stronger For Longer (April 11, 2011)

The Australian strategy team at Credit Suisse notes that on average a 1% rise in commodity prices leads to a 0.4% rise in the AUD-USD exchange rate. The broker's senior resource sector analyst largely concurs, having for twenty years assumed a 50% correlation. The Aussie is known globally as a “commodity currency” on this basis.

Given the Australian economy relies completely today on commodity exports, the label is justified. Australian exporters sell their materials to customers in exchange for US dollars, which are then sold in exchange for Australian dollars. Increased global demand for Australian commodities flows through to a higher terms of trade and thus a stronger GDP, which in turn suggests inflation implications. The RBA responds to the threat of inflation by raising interest rates, thus expanding the interest rate differential between a commodity “have” and the “have not” economies. A higher differential attracts greater fixed interest investment from offshore.

The Aussie began 2011 at an exchange rate of US$1.02, so at US$1.10 the rise is 7.8%. In October 2008 the Aussie hit US$0.62, so its two and a half year climb is worth 77%. Australia, as it turned out, never really hit a GFC recession so the currency move does not suggest it has been dragged out of one. If anything, businesses outside the resource sector would suggest, Australia is in a recession now. Despite low unemployment, it sure feels that way.

The rise in the Aussie accelerated in the month of April. At the same time, commodity prices were also mostly on the rise in USD terms. Under the above suggestions of historical commodity price-to-Aussie correlations, rising USD commodity prices should translate into lower rises, but rises nevertheless, in AUD commodity prices. But in the last month copper, in AUD terms, is down 9.8%, notes Credit Suisse. Zinc is down 11.7%, nickel 7.6%, aluminium 1.1% and thermal coal 6.7%. Rises have been experienced in AUD oil and iron ore, but only of 1% each.

Something's wrong. Credit Suisse determines the Aussie to be 7% overvalued.

“The run in the AUD has become more concerning from an ASX earnings perspective,” suggests RBS, “as it has pushed well beyond commodity price trends. We believe yield differentials are rising in prominence and attracting funds flows.”

RBS notes strong offshore demand for Australian corporate paper has been evident in 2011, but anecdotal evidence suggests Australian bank shares have been highly sought for their dividends, leading to bank share outperformance. The Aussie has surged since its brief dip to 98 when Libya hit the headlines and the tsunami hit Japan. In the meantime, the G7 has intervened to weaken the yen and the Fed has indicated it will continue reinvesting maturing assets after QE2 expires.

US investors might like our banks and corporate bonds but the Japanese, for one, love investing in Aussie government paper. The Japanese have huge savings and a rapidly ageing population, and their domestic real interest rates are negative. How does one invest for retirement? Scorn negative real local bonds and invest in Aussie bonds on huge interest rate differentials. Kiwi bonds are just as popular. (So were Icelandic bonds once).

All of the above influences a stronger Aussie dollar before we even start talking increased USD receipts from China that need converting, or before we move on to the subject of those evil, greedy speculators. The bottom line is there is a lot of momentum behind the Aussie dollar at present and it will probably take a solid turnaround in the fortunes of the US dollar, and a swift speculative response against the Aussie, to make a dent. One thing is notable as I sit here watching the ASX 200 take another significant dive, indicative of offshore profit-taking, is that the billions wiped off Australian stock values in the past few days has applied virtually no downward pressure to the Aussie, which is still over 1.09.

It will not help if the RBA were to again raise its cash rate, fearing inflation. Yet the RBA is also fully aware of the disinflationary impact the rising currency is having. RBS analysts have pulled apart the consumer price index to look at those retail prices affected by the currency, and on their calculations such prices fell 1.5% in the March quarter having fallen 1.25% in the December quarter. They include a 7% drop in AV/computer equipment and a record 6% fall in furniture.

The RBA is not complaining, as such price falls help to effectively tighten monetary policy without actual rate rises. But the reality is that underlying inflation is more insidiously affected by labour shortages and by inflation expectations themselves (if you expect inflation you'll raise prices, thus causing inflation). The Aussie appreciation will restrain inflation at the margin, suggests RBS, but the RBA “may be facing much more inflation this year than it currently expects”.

RBS expects the central bank to raise its mid-year underlying inflation forecast to 2.5% from 2.25% and its year-end to 3.0% from 2.75%. It already has its year-end 2012 and 2013 forecasts at 3.0%, being the top of its target range. RBS thus expects the RBA to start raising its cash rate again in August from 4.75% to 5.5% by year-end and 6% by mid-2012. That's three rate hikes by year-end and five in less than twelve months (assuming 25bps increments).

Where would that put the Aussie? And would that impact on Australia's (everything but resources) recession?

Indeed, what is the impact of a strong Aussie on the resource sector itself?

There are several Australian-listed resource stocks which simply report in USD, thus appearing to negate the currency issue. Credit Suisse lists BHP Billiton ((BHP)), Rio Tinto ((RIO)), Mirabela Nickel ((MBN)), Alumina Ltd ((AWC)) and Equinox Minerals ((EQN)).

The same applies to Australian-listed stocks with assets based offshore, which includes Equinox (Zambia), Mirabela (Brazil), and PanAust ((PNA)) (Laos).

BHP, Rio and Alumina nevertheless can't escape their large AUD cost bases, notes CS, which has to be paid for out of those reported USD revenues.

Credit Suisse, like all brokers, does not model stock valuations off either commodity or currency spot prices. To avoid valuation volatility, they use longer-dated assumptions. But what if CS were to hold commodity prices fixed and just raise their AUD assumption by the supposed 7% overvaluation?

Looking at 2012 earnings forecasts, companies suffering more than a 20% forecast earnings reduction would include Mt Gibson ((MGX)), Gindalbie Metals ((GBG)), Panoramic Resources ((PAN)), Alumina, Energy Resources of Australia  ((ERA)) and OZ Minerals ((OZL)).

But as the Macquarie analysts clearly point out, the April rise in the AUD has “increasingly negative implications” for risks to earnings forecasts for the ex-resources market, in FY11 but more so in FY12.

Over the past 18 months, notes Goldman Sachs, earnings forecasts for emerging companies have also been trending down. Aside from the AUD, impacts have been felt from natural disasters and rising oil prices. Profit warnings have increased in recent months.

The good news is that GS analysts believe 27% of companies in their emerging companies coverage universe have upside risk from current consensus earnings forecasts, and only 13% are exhibiting downside risk. Amongst those exhibiting the most upside risk are resources and banks, and downside risks small industrials. GS notes that we are about to enter the May-July “confession season”, in which companies update their June-end guidance ahead of the August result season.

The stocks seen by Goldmans as having upside risk in this period are Aditya Birla ((ABY)), Alacer Gold ((AQG)), ARB Corp ((ARP)), Austbrokers ((AUB)), Challenger Diversified Property ((CDI)), Charter Hall ((CHC)), Domino's Pizza ((DMP)), Elders ((ELD)), Eastern Gas ((ESG)), Flight Centre ((FLT)), FlexiGroup ((FXL)), Henderson ((HGG)), Independence Group ((IGO)), Imdex ((IMD)), Iress ((IRE)), Kathmandu ((KMD)), Monadelphous ((MND)), Minara Resources ((MRE)), Nexus Energy ((NXS)), PanAust, ROC Oil ((ROC)), Seven Group ((SVW)), Tap Oil ((TAP)) and Western Areas ((WSA)).

The stocks seen by Goldmans as having downside risk in this period are Austereo ((AEO)), Australian Infrastructure ((AIX)), Astro Japan Property ((AJA)), APN News & Media ((APN)), Hutchison Telecoms ((HTA)), Infigen Energy ((IFN)), Kazara ((KZL)), Oakton ((OKN)), Platinum Australia ((PLA)), Programmed maintenance ((PRG)), Select Harvests ((SHV)), Spotless ((SPT)), Telecom NZ ((TEL)), Tassal Group ((TGR)) and Transpacific ((TPI)).

The RBA has just released its May statement on monetary policy, and in it it has implied the central bank is now closely watching inflation developments rather than assuming a more benign underlying environment in the months ahead. This suggests rate rises sooner rather than later, albeit not immediately.

In the meantime, Beijing continues to slow Chinese growth but, so far, not to any level that would suggest a hard landing. As the quote which opens this article suggests, commodity prices are now far more correlated to Chinese demand than they are to US consumption. That would suggest the Aussie dollar is also now more correlated to Chinese demand than just a simple USD ratio.

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