1 OCTOBER 2010

Strong $A a Double-Edged Sword

As can be seen in the chart below, the Australian Dollar ($A) has recently appreciated strongly against the USD.  As it approaches parity, it is important to try and understand the underlying drivers and implications of an appreciating $A on the Australian equity market.  
 

While the underlying drivers of the $A are difficult to quantify, a number of factors have contributed to the rapid $A appreciation towards parity, including:

• An improving outlook for the global economic recovery, with concerns around a European debt crisis abating in recent months;
• The recent stronger-than-expected Australian GDP data;
• The expectation that a second round of quantitative easing by the US Federal Reserve; and
• Recent Chinese data releases have been supportive of current or higher commodity prices

A strong $A has a number of implications for the Australian equity market, including:

• The resources sector is a key beneficiary of a strong $A.  While this may appear counter-intuitive given the negative earnings translation impact, a primary driver of the $A is a stronger outlook for commodity prices;
• Offshore flows into the Australian market are expected to increase as global investors should increase allocations to Australia, particularly resources stocks.  Offshore investors benefit from both exposure to the strong earnings profile within the resources sector and an appreciating $A, magnifying those returns if the $A continues to appreciate further.
• Given current balance sheet strength and low cost of USD denominated debt, some believe that there is an increased likelihood of offshore M&A transactions and debt capital raisings

The global economy still appears to be in the early stages of a cyclical recovery.  Commodity prices are strengthening and given the strong domestic backdrop, Australian interest rates seem likely to rise over the next year.  We believe that these combined influences suggest the trend in the $A should still be to the upside in the near term.

Patrick Malcolm
Senior Para-Planner
Authorised Representative No. 278061

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