Dollar the destroyer

The full impact of Dutch disease is being tracked by analysts mainly by their looking at the effect of the higher $A on earnings. Deutsche Bank has issued a currency review that tells a mixed tale. Wesfarmers, Sims, Bluescope, OneSteel, CSR, the materials sector, the gaming industry are all “negatively impacted”. Companies with significant off shore operations, especially in the US will do rather better: James Hardie, Boral, perhaps Billabong. In other areas the impact is expected to be uneven: airlines, health, engineers.

Just how significant currency related earnings downgrades are is a point of debate. Trying to protect against them by hedging has got any number of companies into trouble. And when two fifths of the ASX is foreign investors, there is probably an argument, followed by most big mining companies, that currency shifts are something for shareholders to sort out, not companies. If the share markets are global, let them think globally.

Deutsche has raised its foreign exchange assumption to $US1.01 by end 2012. The trade weighted index is 77.1. If forecasts are going this way, they represent a huge bet on the strength of the $A, which surely must mainly because it is a proxy China play. The fundamentals of Australia’s two speed economy surely do not justify such a large premium:

While the AUD is well above PPP levels, and softer commodity prices of late give less support, we see risk that it remains elevated. (i) US government debt issues could keep pressure on the USD, (ii) notwithstanding recent softness, commodity prices are at elevated levels, (iii) Australia’s current account deficit is declining to levels last seen when the AUD was above current high levels, (iv) Australia offers a short-term yield of 5%+, compared to peers offering below 2%.

Downgrades across resources, and for many industrials:

Overall, this leads to downgrades for the market of almost 5% (in AUD terms).

Unsurprisingly, the largest downgrades are for resources (~10%), given the recent rise has not been accompanied by higher commodity prices as in other episodes.

Across industrials (ex banks), the downgrades are ~2%, with the healthcare and basic materials sectors seeing the most significant downgrades. In other sectors the impact is generally confined to one or two stocks. Interestingly, a range of offshore-focused companies are insulated from the higher AUD through holding debt in foreign currencies and/or through hedging programs (e.g. GMG, BLD, LEI, WOR, TSE, COH, WDC).

Largest stock impacts:

Amongst the ASX100 stocks, the largest downgrades to FY12E earnings are for ILU, OZL, MCC, CTX, STO, OST, BSL, AMC, ALL, and CSL. While stocks that are modeled in USD don’t tend to see much of an earnings impact, the persistence of a higher AUD also affects their valuation. These stocks include BHP, RIO, WPL, FMG, AWC, RMD, ANN, and BXB.

Currency markets are, of course, extremely volatile. Those negative earnings impact could be unwound in weeks if sentiment for the $A takes a downward turn. There is a time mismatch between the speed with which currency movements occur and much slower occurring economic or commercial changes. It is one of the major reasons why money has stopped representing economic behaviour and is increasingly just representing itself.

But for investors, watching that dynamic of money representing itself is important when trying to get good returns.

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