The effect of a rising AUD on Australian shares
September 2010 represented one of the strongest months for the US equity markets. A surge in stock prices of over eight per cent in one month normally indicates the onset of a period of strong economic growth, or at least a period of sustained economic recovery. This market surge however, appears to have been the result of and the promise of more excessive liquidity created by the US Federal Reserve (The Fed). We know this because the US bond market continues to rally to extraordinary levels as represented by ever decreasing interest rate yields.
As equities rose, the US bond market saw yields on ten-year bonds fall to 2.4 per cent. We continue to view these yields as predictive of an ongoing recession in the US. Indeed we would regard further falls in US bond yields as deeply concerning.
Over in Europe, we continue to note the deteriorating fortunes of Ireland and Greece. Protests in European streets over government austerity measures are a warning of the political consequences flowing from the GFC. The responsibility for the repayment of government debt and the reduction in bloated government deficits will need to be shared amongst the wealthy and the poor. Unless this is achieved and seen to be achieved then the emergence of radical political elements will be seen. This is just another risk for equity markets in Europe, which is yet to be discussed.
Back to the US, and the certain result of its weak economy is that the Greenback will continue to depreciate against the Aussie dollar. Our engagement with China, our strong terms of trade, the widening trade surplus, near full employment and the low relative Commonwealth debt suggests to us that the Australian dollar will continue to appreciate. Indeed the fundamentals of Australia continue to be far superior to those of the US, Europe and Japan.
However, the question we must now seriously consider is whether a stronger Australian dollar, at parity or higher to the US dollar is positive for Australian equities?
There is no easy answer to this question, but what follows is our view of the effect of the rising Australian dollar on various sectors and companies in the Australian market. At the outset we can now confidently predict that index investing in Australian stocks will produce poor returns compared to active stock selection. This is not a bold prediction when you reflect on the last twelve months of the Australian market. For instance, we have witnessed massive outperformance of companies with high ROE who are not directly exposed to the affects of a weakening US dollar or US economy.
First, a critical part of the Australian market is our major resource companies. At this point we note that the rising Aussie dollar is beginning to negatively affect the valuations of BHP Billiton Limited (BHP) and Rio Tinto Limited (RIO). Both companies have benefited from record commodity prices and record volumes. At this point, this has more than offset the currency affect. Nevertheless, a move above parity to the US dollar will begin to negatively affect profits and profitability of both companies.
Further, it is likely that a revamped resource rent tax will be introduced at some point and will lift the rate of tax paid by these companies. It is also worth remembering that resource companies ferociously re-invest capital and they will struggle to achieve high rates of return on reinvested equity as the Aussie dollar rises. While we are opposed to recommend the sale of our major resource companies, we can see difficulties ahead based on the currency.
Reported profitability and profits of resource companies will be affected by the currency. However, they will not suffer a fall in the level of Chinese demand for our commodities. Continued volume growth, mine expansion and infrastructure spend, does support the outlook for mining servicing companies and engineering groups. These companies are not directly affected by the rising dollar. Whilst we do prefer mining servicing companies to engineering groups due to a lower need to reinvest capital, we note that we have already seen a substantial lift in stock prices in these companies [e.g. Monadelphous Group Limited (MND) and Fleetwood Corporation Limited FWD)]. There are pockets of value here, but they tend to be in smaller emerging service companies who do have to prove that they can manage growth from their low base [for example, Forge Group Limited (FGE) and Matrix Composites and Engineering Limited (MCE)].
The currency will have little effect on our banks whose biggest short term issue appears to be achieving asset growth and margin improvement as their offshore funding lines are tightened. We have read commentary suggesting a higher Aussie dollar will lower the offshore liabilities of our banks, but this is incorrect as banks must fully hedge their offshore funding to protect their capital. We remain comfortable with our banks, but we suggest that the ROE achieved three to four years ago of over 20 per cent will not be achievable over the next few years. Our banks are well capitalised, but offer limited growth and should be acquired on pullbacks of at least five per cent from current levels.
The big beneficiaries of the rising currency are definitely our importers and particularly our retailers of clothing or electrical goods etc. While gross margins will increase with a rising dollar, we should note the effects of heavy price discounting. To this end consumer sentiment is important and the recent comments of the RBA intimating higher interest rates are not positive. A business's supply arrangements also need to be understood. For instance a retailer like JB Hi-Fi Limited (JBH) does not get the full benefit of the currency as its suppliers deliver in Australian dollars. Other retailers have different hedge strategies and generally will not immediately benefit from a rising dollar if (say) currency is hedged six months in advance. Ultimately a sustained rise in the dollar will benefit retailers, so long as consumption and retail sentiment remain positive.
Our property companies are a mixed bag and do not offer compelling value at present. However, they are generally sheltered from the Australian dollar. The major property group that is affected is Westfield Group Limited (WDC) who has a substantial US exposure. Thus in the case of WDC, we do see how a powerful Australian business model can be affected by a very poor US retail outlook.
The Australian building supplies sector is generally one that is sheltered from the effects of changes in currency. Despite this, both James Hardie Industries (JHX) and Boral Limited (BLD) have ventured into the US and will suffer from a very weak US building cycle and currency. It is easy to avoid these companies and focus on the pure Australian building supply companies such as Brickworks Limited (BKW) and Adelaide Brighton Limited (ABC) should they fall into value. We do note however that building supplies companies are cyclical, require significant reinvestment of capital and do not maintain high returns on equity.
Other major Australian companies which are negatively exposed to a rising Aussie dollar include CSL Limited (CSL), Computershare Limited (CPU), Billabong International Limited (BBG), QBE Insurance Group Limited (QBE), News Corporation (NWS) and Cochlear Limited (COH). These are all major companies which attract a constant flow of index funds, which buy shares based on market capitalisation rather than valuation. In other words they will always attract fund flows, but this will not translate into share price performance over time because they will struggle to lift profitability in this current climate. Indeed they could significantly disappoint the market with some trading updates later in the year which reflect the sustained appreciation in the Aussie dollar.
Other beneficiaries include companies who pay international prices for raw materials of fuel. Both Qantas and Virgin have pointed to a substantial fall in their fuel costs and a potential reduction in the capital/leasing costs of aircraft. In spite of this, we do not like these businesses because they commonly overstate their profits by utilising off balance sheet financing practices. Also capital reinvestment often exceeds their depreciation rates.
In the main, we do not believe that a rising Australian dollar to levels above parity is a positive for the Australian equity market. Indeed the rising dollar is one reason as to why the Australian market has underperformed most other developed country markets this year in constant dollar terms. It is interesting to reflect that since late May, the Australian dollar has revalued by 20 per cent against the US dollar and thus a US based investor has achieved a substantial lift in the value of Aussie dollar equities during this relatively short period. At some point, this will lead to selling by these offshore holders as they lock in profits.
In terms of MyClime valuations, please note that we have taken into account the rising Australian dollar in our two inputs of valuation.
First, the required return of a company has been adjusted should it be exposed positively or negatively to currency moves. In our derivation of required return the sensitivity to currency moves will mean that a high return is required.
Secondly, the assumed Normalised Return on Equity (NROE) will also have been adjusted so long as market forecasts have noted the assumptions in the forecast for currency. If market forecasts have not done so, then our analysts have made an adjustment where required.
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Published: Tuesday, October 26, 2010