Australian dollar to fall

There’s an institutional research report about the Australian dollar that has gained a lot of attention around the world in the past few days. It is by a boutique insto research firm called Variant Perception. Called “Australia: The unlucky country, it argues:

A substantially weaker currency in Australia is inevitable given fundamental factors. Oversized banks dependent on external financing, a bursting housing bubble and a slowing Chinese economy are all fundamental factors which are likely to weigh on the currency. As we explain, a weaker currency can either come in the form of the RBA reducing interest rates or a balance of payment-like crisis in which foreigners pull funding from the banking sector. In both cases, the RBA would likely have to expand domestic liquidity substantially to prop up the banking system.

  • Australia is a classic case of the Dutch Disease. The Dutch Disease denotes the loss of competiveness in the tradable manufacturing and industrial sector as a result of a resource/commodity boom which leads to an overvalued real exchange rate. In Australia, the mining sector has crowded out almost all other sectors of the economy and also funnelled credit and liquidity into a housing bubble in the real estate sector.
  • Australia net external debt levels resemble those seen in the European periphery; the currency is fundamentally vulnerable. Australia has been running a persistent current account deficit since 1980 and the country’s negative net international investment position is one of the largest in the world. On this background, the strong currency makes no sense and fundamentally the currency is very vulnerable to capital flight from the banking system.
  • Australian banks and corporates rely heavily on foreign funding; the RBA will have to provide liquidity through LTROs. Structural global deleveraging and stop-go flows add volatility for Australian banks. As the housing market continues to correct, it may be difficult for Australian banks to fund themselves. Lowering interest rates will hurt the margins of the banks, and the RBA will likely be forced into domestic liquidity operations to prop up its banks.
  • Two options to weaken the currency, lower rates or a balance of a payments crisis. The Australian currency will weaken in one or two ways. Either the RBA gradually reduces interest rates to accommodate a structurally slowing economy and a relative end to the mining boom or the economy will suffer from a balance of payment crisis as external financing dries up due to the decline in the terms of trade exposing the negative current account.
  • Australia’s commodity sector is tied to a structurally slowing Chinese economy. The commodity sector remains a force to be reckoned with in Australia and will remain cyclically tied to China. Still, the Chinese economy is structurally slowing down and this will impact the growth rate of mining and resource related activities in China. Australia is likely sitting on significant overcapacity in the mining sector which will be difficult to transfer to other sectors.
  •  The Australian consumer is overlevered, but demographics are relatively positive going forward. The correction in the Australian housing market is far from over and the Australian households remain overlevered. Yet, the savings rate has already increased substantially and in the long run demographics look far more robust than in eg Europe.
  • Stay long government bonds in Australia on convergence towards low interest rates in the rest of the OECD. Whether it be as a result of the RBA gradually cutting rates to reflect slower growth or because foreigners start bidding up Australian bonds due to carry, yields are going down in Australia. We continue to like being long government bonds in Australia.
  • Our long-term technical buy signal on Australian equities is in effect, but avoid miners and banks. We currently have a long term technical buy signal in effect on Australian equities as a result of the recent sharp sell-off. This is usually followed by good returns over the next 6 months or so. Although the market cap on the ASX 200 strongly favours overweight in mining and financials (market weight), we would avoid these two sectors and buy into defensives (consumer staples and health care) as well as industrials. Industrials and manufacturing will outperform on lower interest rates and a weaker currency. The gradual end to Dutch Disease will eventually lead to outperformance of the industrial sector. In the long run, our view is that the Australian equity market cap will re-weight away from mining and financials towards industrials and eventually consumer and retail.
  •  Buy CDS on big four Australian banks. Australian banks remain the weakest link in Australia’s economy, and they are too big to fail. We like buying CDS on Australian large cap banks as an outright trade or as a hedge against the long-term technical buy signal on Australian equities mentioned above.

Happy reading.

August 2012 – Australia (1)

Comments

  1. GunnamattaMEMBER

    If these guys can get basically everything right, why is it that our own RBA (which has a good track record) keeps casting the economy in a completely different light?

  2. This is a point worth repeating:

    “Two options to weaken the currency, lower rates or a balance of a payments crisis. The Australian currency will weaken in one or two ways”.

        • Sweeper

          Lowering interest rates will TEND to create capital outflows. The effect is immediate and could be large and catastrophic depending on the perception of where it is all going to end.
          Secondly lowering interest rates TENDS to increase consumption and decrease saving….that is the aim. Our marginal propensity to import, I’m guessing, probably stands at at least 40%…maybe much higher (once again if anyone has ANY figures on this I’d apprecialte them)

          With our current structure, our fiscal and IR settings we will probably get little if any increase production or import replacement replacement. This is especially the case in the short term. The harm that has been done will take multi-decades to repair

          • “Lowering interest rates will TEND to create capital outflows”.

            Correct, and this is exactly what we need to weaken the currency (less money coming in & more money going out).

            The questions is: Do you want the capital flows and currency to adjust 1. Now because the RBA says enough is enough (overvaluation is creating too many risks) and decides to cut rates or 2. Later because global investors decide enough is enough, that Australia has reached the limit of external solvency (BoP crisis).

            On your second point, if cutting rates to weaken the currency is inconsistent with the inflation target, fiscal policy needs to tighten (per Corden’s Option 3). But the first priority has to be to cut rates.

          • hmmm. I always thought that a freely floating currency regime means that for every buyer there is a seller so an imbalance on the capital account must be met by a offsetting imbalance on the current account.
            Suspect a change to fewer inflows on the capital account cannot accompany a deteriorating current account

          • Sweeper

            I’m a bit tired just at the mo so I’m in no condition for this 🙂

            We were talking the possibility of a BoP crisis. I agree with your postulations as far as they go but I consider you are not following the line of thought through far enough.
            So we get a BoP ‘crisis which crashes the dollar. It doesn’t matter too much if it’s not a ‘crisis’ or a ‘crash’. We can use the lesser dramatic outcome of a substantial decline in the A$. This is our desired result.

            Now non-tradable goods are running at an average annual inflation rate of 4 to 5%. Non-tradable at 0% in the as a result of a rapidly rising currency. The corollary is that FOB prices are rising at the rate of about 10% annually on average.
            Now we send the dollar from $1.05 to say .85 on the back of lower interest rates. What’s your inflation rate and what is the RBA’s charter?

            I’m not actually arguing against you. I’m arguing against the presumption that the substantially lower dollar will be some sort of cure-all without other substantial reforms that will take up to decades to have real impact. Further the benefits of the devalued dollar are likely to be immediately lost without other substantial reforms.

          • Smokes
            You’re right. There is a buyer and a seller but at what price?

            Secondly, just quietly, we were talking about a BoP crisis, i.e. a moment in time, not a Current Account issue which is a somewhat longer term.

            However, let’s take your statement and let it run a little. In order to wipe out the CAD in the face of capital outflows you must either
            1. Tax the hell out of everything and cut govt expenditure
            2. Raise interest rates to what would prove, in our case, very high levels
            3. Have a severely devalued dollar which TENDS to raise exports but will send the cost of imports sky-rocketing with all the resulting inflation and feedback producing higher and higher inflation.(as per my reply to sweeper.
            4. As a result of 3 the RBA raises rates.

            Back to square one.

            Now what would happen would be some combination of all 4 above. In the face of vested interests and stupidity the other reforms would not be attempted and, in any case, they are very long-term issues.

            The result would likely be severe dislocation and some devastation for quite a few.
            Life would not be all that pleasant for many of us.
            Those with power..big unions, big business with monopoly power, public service, would just go for all the adjustment in wages they need to compensate them for any hardship they might have otherwise had to endure.

            Life would become very difficult for the rest.

            Smoker I’m old enough to have seen it all here before.

    • GunnamattaMEMBER

      What I find interesting/disturbing is that if they go for a BoP crisis then they are going to end up with an AUD correcting in one or two days (OK that is an exageration).

      But on the other hand if they reduce rates, they may well be thinking that all they will do is stoke the real estate bubble, maybe unleash some inflation – softening up the economy for when it really will have a BoP issue.

      • The real estate bubble has ended. The RBA need to focus on the continuing damage and risks created by the current overvaluation.

        If they really are hesitant to cut rates because they are worried about re-inflating house prices, then they are not doing their job.

        • Sweeper…the RBA may be doing its job. We need fundamental fiscal and structural change to complement what the RBA does…over to US and the politicians and power brokers we elect!!!!!

  3. Gunna

    To me it looks like one of those knife-edge situations. I am personally in teh bearish camp. However the impact of the inflow of Foreign capital, especially Chinese armed with virtually worthless American paper that we have to accept, seems to me to be the wild card.
    If it keeps coming despite the slow-down then we can keep over-consuming and building houses and shopping centres.

    A slow-down may well suit the Chinese as they will be able to pick up resource assets cheaply. The Asians think in time frames of multi-decades…unlike us who now think the long term is Christmas 2012.

    • “Chinese armed with virtually worthless American paper that we have to accept, seems to me to be the wild card.”

      Not an issue as long as we exchange piles of dirt for piles of plasma tvs.

      • Sidelined…we aren’t exchanging piles of dirt…we are exchanging piles of assets for plasma TV’s and SUV’s!!!
        That’s the problem!

    • GunnamattaMEMBER

      ‘A slow-down may well suit the Chinese as they will be able to pick up resource assets cheaply.’

      I actually made that very pointy the other day to some people. Actually I am surprised they (the Chinese) havent engineered to sudden drop in the AUD just for ‘trading’ purposes. For they could buy Aust assets cheaply, more so if they thought there would be demand for them in the longer term.

      • I got to laugh that the whole world is starting to see through the bull#$it of the RBA and Aussie Govt. I think before long it will be called the not so lucky country.

        This was very interesting

        “The country’s consumer borrowing stood at 149.7 percent of disposable income in the first quarter, compared with a record 156.3 percent in 2006, RBA data show. That’s higher than the 133 percent Americans accumulated at the peak of the U.S. subprime mortgage boom, according to the Federal Reserve Bank of San Francisco.”

    • christopher dahl

      a63

      Yep, you are right on this one.

      This is effectively an update on the Australian chapter in Jon Tepper & John Mauldin’s book – Endgame.

      Its a damn good read – highly recommended if you haven’t read it.

      Cheers

    • I’ll say it again. Go to the CX advisory website and look at the Guru grades page. Maudlin by name and Maudlin by nature but he only has a success rate of 40%. Use him as a contrary indicator if you use him as anything.

  4. Until the AUD breaks below last Oct’s low at .9580 ish, this is still a big trading range , extending the sideways move since around Sept’10.

    Theres a lot of room for AUD to play in before any trend change can be claimed.

  5. As in most bearish analysis, a major point is overlooked: the other side of the FX pair. So AUD is going to weaken against what? USD? But the US wants and needs a weak currrency.

    The analysis should include the obvious point: all fiat currencies will continue to weaken vs real money.

    • Until the IR differential (AUD vs US, JPY etc) is addressed, any talk of a significantly lower AUD is premature and frankly, jawboning.

      Carrying AUD is still a very profitable trade.

    • Jumping jack flash

      That’s an interesting point and I agree, the US is intent on keeping their currency low to stimulate exports and reclaim manufacturing from Asia.

      Won’t this mean then, that essential items such as food and energy will continue to rise in price, all things being equal?

      Brace for more stagflation?

  6. The Unlucky Country: Go tell that the most in the UK, Ireland, Spain, Greece, Italy, US, NZ etc.

    A ‘classic case of Dutch Disease’ that has crowded out other sectors – sweeping generalisation and inaccurate. Where is the supporting evidence for that. To date near full employment, stable housing market and so on. The resources sector has carried the rest of the economy.

    ‘Australia’s commodity sector tied to China’ Stating the bleeding obvious – the entire economy is tied to China – think Bear Feller’s comment that 90% of GDP growth in recent years attributable to resources sector and ToT.

    Any report that launches into the Dutch Disease theory absence of evidence indicates to me wariness may be required when judging other assumptions.

    For example:

    “Industrials and manufacturing will outperform on lower interest rates and a weaker currency. The gradual end to Dutch Disease will eventually lead to outperformance of the industrial sector.”

    Just like industrial and manufactures in above mentioned countries have outperformed on the low dollar? Yeah, right. A sub-standard and superficial report.

      • Claims of a ‘classic case of Dutch Disease’ crowding out other sectors without one shred of statistical support is a sweeping generalisation.

        I expect an ‘institutional’ report to provide data, not hearsay.

    • agree with some of your comments 3d1k but this bit is mostly true:

      “Industrials and manufacturing will outperform on lower interest rates and a weaker currency. The gradual end to Dutch Disease will eventually lead to outperformance of the industrial sector.”

      for industrials anyway, which is why you want to be owning stocks and not listening to permabears becuase they dont understand this. You are already seeing the outperformance in industrials now as this plays out and its only the beggining.

      “Just like industrial and manufactures in above mentioned countries have outperformed on the low dollar?”

      yes, that is right. look at EPS for industrials in the US and Europe.

      in your defense though the report does generalise whats happened overseas and apply it here.

  7. The RBA (Debelle) put out a piece last year about how not all current account deficits were bad. As they pointed out, it frees firms’ investment decisions from domestic financing constraints … Bad current account deficits “are those which result from domestic distortions or excessive fiscal positions…”

    So i am not convinced but the Variant Perception paper’s focus on the current account deficit. Also worth recalling Huw McKay’s (?) piece from Westpac where he rightly pointed out that the current inflows to Australia …

    “…the financial system (as of now, almost exclusively banks) are joined in sourcing international capital by the Commonwealth and state governments, and by the corporate sector, who are accessing a mix of direct and portfolio debt and equity liabilities.

    Furthermore, with loan to deposit ratios moving favourably for the banking system as national savings rise, the proportion of local credit demand being met by offshore debt issuance is waning, and the term of the funding being sought has lengthened.”

    Not to say the AUD is immune from falling, and probably should. Indeed, as McKay goes on to point out “Australia’s current account financing dynamics have already begun to shift back towards historical norms (the cycle is turning) – although it is extremely unlikely that the situation will go all the way back (secular elements remain).

    The shifting balance of these forces will serve to reduce the currency’s present level of resilience during times of stress. That is no bad thing. The flexible exchange rate is a key pillar of Australia’s counter cyclical response mechanism.”

  8. shanem
    August 29, 2012 at 2:14 pm

    “The RBA (Debelle) put out a piece last year about how not all current account deficits were bad. As they pointed out, it frees firms’ investment decisions from domestic financing constraints “…

    More importantly it frees consumers from constraint on consumption spending.

    A short term CAD for reasons of investment is one thing. A chronic CAD for 50 continuous years is another.
    Note that Debelle doesn’t ever deal with the asset sales that have resulted from these policies.
    Huw Mackay never thought about a CAD in his life. When I raised the issue of CAD’s with him a few years ago he just looked blankly at me and said “But Australia has always run a CAD” That you can get away with it for along period doesn’t mean it is the best thing to do for your country and its people.
    Indeed there are long-term demographic and prosperity trends that are now running that will impact us very heavily because of these poor short=termist policies that have been in vogue for 50 years.

    Once more re increased savings rate…as a nation we are not saving more. The private sector has slowed credit creation…not reversed it. More importantly the slowing in the private sector has been matched by acceleration in the growth of public sector debt…largely financed from offshore.

  9. Isn’t the flip side suggesting that the USD will rally or hold its value at least? I think it will- just interested to hear what some US mega bears might think…

  10. 22 pages and not a single mention of the superannuation savings pool? A common mistake made by foreigners.