AUD Weakness Changes Oz Market Dynamics

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By Rudi Filapek-Vandyck, Editor FNArena

There are no two ways about it: the most important event over the past week has been the collapse of the Australian dollar with global hedge funds launching a coordinated attack at the same time as the greenback has staged a come-back.

Australia should thank George Soros and Stanley Druckenmiller because what the government and the Reserve Bank couldn't achieve over the past year or so has now quickly turned into a self-fulfilling process.

The result is now that persistent doubts about the outlook for corporate profits in Australia have been relegated to the sidelines. The Australian non-mining sector may well still be looking forward towards ongoing challenges and further weakness into calendar 2014, hence the impact from a sharply weaker Aussie dollar simply cannot be underestimated. The share market clearly hasn't, judging by its recent strong performance.

Some economists have already likened the Aussie's US5c drop in less than a weeks' time to a 25 basis points cut by the RBA. Further weakness thus translates into further relief without the RBA lifting one finger. Conclusion number one is an easy one to make: AUD weakness will keep the RBA on the sidelines and might even translate into no more cuts ahead.

The implication of this is that market leadership should switch to cyclicals and to domestic industrials for which the persistently strong AUD has been a significant barrier in the years past: think local steel manufacturers, hotel owners, exporters and the tourism industry.

Usually, when the AUD weakens this is not good news for mining and energy companies. This message was again brought home by an update on share market and AUD correlations by the team of quant analysts at Macquarie. The report shows that, on past experiences, share prices for the likes of Lynas ((LYC)), Regis Resources ((RRL)), Asciano ((AIO)), Perseus Mining ((PRU)) and PanAust ((PNA)) should have tanked alongside the sharp drop in AUDUSD. So why haven't they this time?

It all relates back to what is causing AUD to rise and fall in the first place. If the Aussie dollar strengthens on the back of a rally in commodities prices, then share prices of mining and energy stocks rally too, despite the fact that a stronger AUD represents negative news. The market tends to focus on the good news behind the Aussie dollar's rise.

Similarly, when AUDUSD falls because commodity prices are plunging then the good news of a cheaper currency should not lead to rising share prices. It doesn't apply this time because of a marked difference in timing: commodity prices have already plunged taking share prices down sharply over the past three months. All that time the Aussie dollar stoically remained above USD-parity. Now that weakness has kicked in, investors are taking the view that weaker commodity prices had been priced in, but not yet the positive impact from a weaker AUD. So this time around it is different and a weaker AUD is good news for resources profits and share prices.

Exit the Macquarie quant analysis update on AUD sensitivities in the share market. Except for the fact the report highlights the obvious on the positive side: major exporters stand to benefit in a major fashion. On top of the table showing the highest positive correlations with a weakening AUD sit Treasury Wine Estate ((TWE)), ResMed ((RMD)), CSL ((CSL)), Woolworths ((WOW)) and SP Ausnet ((SPN)). The first three are no surprise, but numbers four and five certainly are.

Clearly there are more dynamics in play than simply price competitiveness and the translation of overseas profits into local dollars for Australian shareholders.

Before I continue, let's take a brief pause. The Aussie dollar has quickly lost about US5-6c, does this automatically imply more weakness is but a given?

No, it's not. In fact, in-house modeling at National Australia Bank and at RBS Morgans suggests fair value currently sits around US98c and FX experts at CommBank suggest it won't be long before AUD surges back above USD-parity. The latter seems like a big call with investment heavyweights Soros and Druckenmiller, and a large army of follow-that-trend hedge funds, positioned for more weakness. Newsletter publisher Dennis Gartman recently commented that when such icons of successful trading go all-in it simply doesn't seem wise to move into the opposite direction. A piece of wisdom even the economists at NAB took into account when they updated their modeling: AUDUSD may seem fairly priced at around US98c, it is more likely that further weakness remains in store.

Analysts at Goldman Sachs have now lowered their AUDUSD forecasts to 90c on a twelve months horizon. In their view, "Poor commodity price dynamics in both the near and the medium term, sharp retracement in capital investment plans by major Australian miners in the past fortnight, a ballooning federal budget deficit, poor domestic data flow and a cut in the cash rate by the RBA have all assisted the A$ lower in recent weeks. However, it is the combination of the US Fed edging closer to tapering QE, the exhaustion of attractive yield opportunities in Australia (from an offshore investors perspective) and Australia’s extraordinarily high correlation with US bonds that look set to chip away at the primary determinant for why the A$ remained at elevated levels – the seemingly insatiable appetite of foreign investors for Australian yield."

Traders and speculators in currencies more often than not use technical signals and patterns in their strategies, so investors may want to keep an eye on the following support and resistance levels (thanks to Gain Capital's Chris Tedder):

– On the way down: 0.9710 is the next key level of support, then 0.9665, then 0.9580 and then 0.9385 (low since September 2010)
– On the upside: resistance is located around 0.9870 (200day SMA) and then USD-parity

Probably the most important conclusion in the Goldman Sachs' update, at least for investors in the Australian share market, is that "the declining A$ will not only provide a mechanical lift in our financial conditions index, it would likely set off an earnings upgrade cycle for the Australian equity market".

Yet, most stockbrokers and analysts have been taken completely by surprise by events from the week past. Only a month ago those same analysts at Goldman Sachs had raised their AUDUSD forecasts for the short term to 1.05 and so far not one of the stockbrokers that is monitored closely by FNArena has issued a dedicated research report on what the sharp decline in AUD actually means for listed companies, apart from said re-release by Macquarie quant analysts. No doubt, this hiatus will be filled in the days ahead (one assumes).

A search through the in-house archive at FNArena has generated a good dozen of dedicated AUD reports by the major stockbrokers since August last year, suggesting the currency hasn't genuinely been a major focus over the past nine months. No surprise thus, most AUD-oriented research reports are pre-2013 and quite a few predict AUDUSD was to remain above parity for much longer. A case of complacency creeping in? Possibly. We all knew/assumed the Aussie dollar looked overvalued, but having resisted just about everyone's call for a weaker AUDUSD, maybe we had collectively given up on it ever actually happening?

Below are the most interesting conclusions taken from AUD-specific research reports issued since August last year:

– the impact of a weaker AUDUSD on profits of certain smaller mining companies can be nothing short of spectacular, in particular smaller miners that are only marginally profitable in the present context. UBS last week calculated it only takes US5c to boost profits for Western Areas ((WSA)) by 159%, for Alumina Ltd ((AWC)) by 138% and for Perilya ((PEM)) by 125% – all else being equal. Other mining companies that should see a spectacular boost to their earnings per share include Grange Resources ((GRR)) at 76% impact, Whitehaven Coal ((WHC)) at 64%, Ivanhoe ((IVA)) at 44%, Mincor Resources ((MCR)) at 43%, Atlas Iron ((AGO)) and Mount Gibson ((MGX)) at 42% and PanAust ((PNA)) at 41%. Imagine what a further US5c fall could mean for those companies in the year ahead!

– BHP Billiton ((BHP)) and Rio Tinto ((RIO)) should receive a boost to their earnings per share of circa 6% and 5% respectively (all else being equal)

– Coca-Cola Amatil ((CCL)) is a net beneficiary of a stronger AUD with analysts at Morgan Stanley noting "the correlation for bottlers in the Coke system to movements in their local currency/USD share price is remarkably strong". Traditionally, the Coca-Cola Amatil share price tends to be a beneficiary when AUD weakens but most likely because that's when commodity prices tend to be weak too (The company is a major beneficiary of weaker input costs)

– Amongst retailers, The Reject Shop ((TRS)), Pacific Brands ((PBG)), and Premier Investments ((PMV)) are all major beneficiaries of a stronger AUDUSD because they all source product directly out of China. The current reversal in trend is thus a major negative. The opposite should apply to supermarkets and David Jones ((DJS))

– In the healthcare sector, ResMed has most exposure/leverage to AUDUSD while for CSL the dominant currency pair is USDCHF (Swiss Franc). Consequently, AUDEUR and AUDCHF are more important for CSL than AUDUSD

– Cochlear ((COH)) should benefit from a weaker AUDUSD as FX hedging programs expire in the years ahead

– Macquarie released an interesting report on AUD sensitivities in September last year, arguing there are companies listed in Australia whose share price tends to respond positively when the Aussie dollar weakens while there is no notable impact on their bottom line. These companies include Telstra ((TLS)), Ansell ((ANN)), DUET ((DUE)), Metcash ((MTS)), Spark Infrastructure ((SKI)), SP Ausnet, Tabcorp ((TAH)), Tatts ((TTS)), Invocare ((IVC)), Sigma Pharmaceuticals ((SIP)), Singapore Telecom ((SGT)), Austbrokers ((AUB)), Prime Media Group ((PRT)) and Cabcharge ((CAB)).

The confusion from the Macquarie report is probably caused by the reason as to why AUD is weakening. Is it because of a general retreat in risk appetite? This has often been the case in the years past and potentially explains the high correlation in the past for the many defensive havens on the Macquarie list.

– According to the same Macquarie report, major beneficiaries of an AUDUSD depreciation, both in terms of EPS and share price risk, include CSL, Treasury Wine Estate, Sonic Health Care ((SHL)), Amcor ((AMC)), ResMed, Aristocrat ((ALL)), Aurora Oil and Gas ((AUT)),Navitas ((NVT)), ARB Holdings ((ARP)) and Domino's Pizza ((DMP)).

– For energy companies such as Woodside Petroleum ((WPL)) any impact from AUDUSD is more muted than in the past due to AUD denominated gas contracts

All in all, it appears a weaker Aussie dollar puts the local share market somewhat in a sweet spot as the impact is a clear positive for most stocks and sectors. At least until inflation roars its head forcing the RBA to refocus on tightening, but that's not a concern right now.
 

(This story was originally written on Monday, 20 May 2013. It was published on the day in the form of an email to paying subscribers).

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At the very least, my latest e-Booklet "Making Risk Your Friend. Finding All-Weather Performers", which was published in January this year, managed to accurately capture the Zeitgeist.

All three categories of stocks mentioned in the booklet are responsible for the index gains post 2009 and this remains the case throughout 2013.

This e-Booklet (58 pages) is offered as a free bonus to paid subscribers (excl one month subs). If you haven't received your copy as yet, send an email to info@fnarena.com

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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Rudi On Tour in 2013

– I will present and contribute during the 2013 National Conference of the Australian Technical Analysts Association (ATAA) at the Novotel in Sydney's Brighton Beach, June 21-23

– I will present to members of AIA NSW North Shore at the Chatswood Club on Wednesday 11 September, 7.30-9pm

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