It was interesting to look back at the corresponding edition last year - 30th October 2007. In that edition we were looking at exchange rate movements with some talk in the press about the Australian dollar reaching parity with the US dollar. Well we now know that it nearly got there reaching a peak of 98 cents in July. How the mighty Aussie dollar has fallen now lingering around the low 60s and that high only thanks to some intervention on the part of the RBA.
In this edition we revisit the relationship between the Australian dollar and other currencies and how movement in the Australian dollar impacts on investments.
The recent movements in the Australian dollar compared to other currencies has seen a significant depreciation in value across the board. Since the beginning of 2008 until Monday 27th October we have seen it decrease:
- 29.7% against the US Dollar (36.7% from its peak in July)
- 10.8% against the UK pound sterling(19.8% from its peak in July)
- 17.7% against the Euro(23.7% from its peak in July)
- 41.2% against the Japanese Yen(46.0% from its peak in July)
- 25.3% against the Trade Weighted Index#(30.8% from its peak in July)
There can be many reasons for movements in the value of a currency but the basic story is about supply and demand. Since December 1983 Australia has used a floating exchange system. Under this system changes in demand and supply of a currency affect its value. Demand for the Aussie dollar is affected by
- financial flows into Australia from overseas investors which in turn is affected by the level of interest rates and level of confidence in the economy,
- expectations of a future appreciation in the $A will increase demand by speculators,
- demand for Australian exports
Supply on the other hand is represented by:
- financial flows out of Australia
- speculators expecting the $A to go down
- demand for imports
Given the recent depreciation of the $A there appears to be greater pressures on the supply side of the currency which has forced the exchange rate downwards. A couple of key theories that are being suggested as a cause:
i) the Aussie dollar is seen as a commodity currency as the Australian economy is heavily reliant on the sale of commodities. As the prices for these commodities fall so to does the exchange rate.
ii) Our currency and financial markets are seen as a riskier and money at present is flowing to historically safer places particularly the US dollar and the Japanese Yen.
These are reasonably simplistic economic theories but seem to make sense given the current markets.
What Does This All Mean for Investors?
Mainstream media tend to latch on to the stories where the fall in currency is not so well received - for those people going on overseas holidays or buying imported goods.
However for mainstream investors (who are not trading currencies) the major implication of changes in exchange rates for investors is that it changes the value of international investment in terms of Australian dollars. If you bought investments in the US at the beginning of the year one $A would have bought you 88.16 US cents of investments. If you wanted to convert those 88.16 cents back into $A on the 27th of October you would have been able to buy 142.33 Australian cents (at the exchange rate of 61.94). Without taking into account investment returns and transaction costs you would have made 42.33 cents on the original dollar.
If the dollar was rising in value the opposite would be true leading to a loss.
So over the past few months while share markets around the world have been knocked around, unhedged international share investments have faired relatively better compared to Australian share investments. Still well and truly negative but at least more palatable.
Our Approach to Exchange Rates
At 'A Clear Direction' we believe that exchange rate movements pose a couple of questions.
- Do we steer clear from international investments because of the risk of exchange rate movements?
- Do we 'hedge' our clients away from exchange rate risks by using global investments that have in built currency hedges against rate changes? or
- Do we try to capture this type of diversification in our portfolios by exposing some of the portfolio to exchange rate movements?
In line with our overall philosophy towards investment markets, we do not believe you can time when exchange rates will rise or fall. Therefore, our philosophy is to incorporate hedged investments in our high yield investments - international fixed interest and listed property. This protects these more regular and higher income sources from exchange rate movements. However we also look to expose investment portfolios to some exchange rate risk and diversification through using un-hedged international share funds. This has worked well over recent months but of course does not work well when the Aussie dollar is rising in value.