Editor’s note: Last week, our Editorial Director Greg Canavan wrote to our paying subscribers in The insider after a fall in the value of the Australian dollar. There are myriad effects this creates for the Australian economy, and it’s important for Australian investors to be aware of this – which is why we want to share this insight with you today. There are undoubtedly downsides to a lagging Australian dollar, but there are upsides as well. If we plan accordingly, there is a way to prepare our investments so that they are ready to rise when the bull market returns. Enjoy…
As I write this Wednesday morning, the Australian dollar is trading at around 62.8 US cents.
This is the lowest it has traded since April 2020, during the COVID panic. Before that, we have to go back to the dark days of the GFC in November 2008. And before that in the early 2000s, with the rise of China and globalization.
You can see it in the long-term chart below:
The Australian dollar is an excellent barometer of global economic growth. When it is as low as it is now, it indicates that something is wrong with global trade.
That “something wrong” is rising interest rates around the world. As evidenced by the sharp drop in the Australian dollar over the past few weeks, those rate hikes are now starting to kick in.
As I mentioned in the Monday Initiated, monetary policy acts with a lag. And we don’t know how long this lag lasts. In his 1969 book The optimal amount of moneyMilton Friedman said that monetary policy works with ‘long and variable offsets‘.
He therefore argued for rules-based rather than discretionary monetary policy. Given the hole central bankers have dug for us over the past few decades, it’s hard to argue that Friedman was wrong.
Either way, the point is the same one I’ve been making for a while now: the Fed continues to tighten while looking for evidence of its effect in lagging indicators.
The sharp drop in the Australian dollar is just another example of the rapid slowdown in global growth that is happening under the Fed’s nose.
But it’s more than that.
Flexible exchange rates mean currencies act as shock absorbers. What made the Great Depression so bad in the 1930s (apart from the easy money upstream) was the rigidity of the monetary system at the time.
Most major currencies were on some type of gold standard. So in the Great Depression, labor took a hit, and so did capital. The US dollar remained strong.
It wasn’t until April 1933 that Roosevelt devalued the dollar against gold, nearly four years after the Depression began.
At that time, unemployment was around 25%, the banking system had collapsed, and the Dow Jones index had already plunged 80% from top to bottom.
Currencies nowadays move against other currencies, so as not to inflict such harsh consequences on labor and capital. Everyone is affected in one way or another by currency movements. Some profit, others lose. But the idea is that the pain spreads broadly rather than narrowly.
For example, a weaker Australian dollar means that imported goods cost more. This is the market’s way of trying to discourage consumption and encourage production. But it may also fuel the inflationary pressures Australia already faces, putting pressure on the RBA to raise rates further.
On the other hand, the weak dollar makes our exports cheaper in the eyes of foreign buyers. It’s good for our food producers and other commodity exporters. But if they need to invest in imported factories and equipment to build new mines and/or new production capacities, this increases the cost of this initial investment.
Another area that will likely benefit from a weaker Australian dollar is high-end real estate. If you’re a cashed-in US investor and see the Aussie dollar down almost 20% against the greenback in six months, a falling real estate market here suddenly looks very attractive.
You can see the other impact of currency movements on the stock market. With Fed rate hikes and the US dollar as the world’s reserve currency, the greenback is the only game in town. It is by far the best performing currency this year.
This is partly why US markets are down sharply this year while the Australian market has fared much better. For example, the S&P 500 is down about 25% from its peak. Meanwhile, the ASX 200 is only down about 12.5% from its peak.
However, if I denominate the ASX 200 in US dollars, as you can see below, it is down more than 27% from its peak:
So, adjusting for currency movements, the Australian market is on par with the US.
Can you see now how floating rate currencies can cushion the effects of global capital flows and economic currents?
But it can only absorb so much before other factors kick in – like imported inflation forcing the RBA to raise rates further. There are many examples in history (especially in developing markets) where central banks have had to raise rates to defend their currency.
If history is any guide, it’s likely nearing a bottom for the Aussie dollar here. But in the short term, with the Fed pushing the US into recession, you can’t rule out more downside.
Much will depend on this week’s (late) inflation figures, due in the US on Thursday. A better-than-expected September figure should see markets – and the Australian dollar – rally strongly. But if it stays higher than expected, all hell could break loose.
There is another currency effect that I want to highlight. It’s about commodities and what our producers get for their products. You see, when the Australian dollar falls and the US dollar price of a commodity remains stable, the Australian dollar price rises.
This has been happening lately, especially with gold and oil. Over the past few weeks, the price of gold in Australian dollars has jumped around $150 an ounce to hit $2,650. Brent, priced in Australian dollars, went from $130/bbl to $150/bbl.
Not all companies benefit equally from this increase. Some have contracts in US dollars, and in the case of the big energy companies, they report in US dollars anyway.
But overall, the higher prices benefit Australian producers. In the case of gold, miner stock prices simply don’t react. I have already shown the table below. The gap between the price of gold in Australian dollars and the ASX Gold index continues to widen:
It just shows you how deep bear market gold stocks are right now. But when the turning point comes, the gains will be substantial, in my opinion.
The “discount” on energy stocks is not as significant. The chart below shows Brent crude in Australian dollars against the ASX 200 energy index. Energy stocks have been in a bull market, unlike gold stocks:
But there is always a discount there. It’s as if energy stocks aren’t convinced that high oil prices will stay. Perhaps with the Fed on course for an inflation war, oil prices will succumb to near-term demand destruction.
As I’ve pointed out before, even with such a strong dollar and Biden depleting the Strategic Oil Reserve to its lowest level since the early 1980s, oil prices remain high.
And thanks to the weak Australian dollar, local currency prices are not far off the all-time highs reached just a few months ago.
That’s why you still get screwed over at the gas arbor.
This brings me back to inflation. A reader recently asked me how I could be both bullish on oil and think inflation is down.
I ran out of time and space today, but I’ll answer that question in an upcoming essay.
Editor, The Daily Reckoning Australia
PS: To see this upcoming trial, you will need to become one of our paid subscribers. If you are interested in Greg Canavan’s ideas, you can subscribe to his service, Fat Tail Investment Advicehere.