The sell-off in the Aussie dollar has accelerated recently and many forecasters are cutting their expectations for the year. CBA recently revised their year end outlook for the Aussie dollar with a forecast that it would fall below $0.60 to the US dollar by the start of 2024. This is obviously bad news for overseas travellers but the impact on investors is more complicated.

There are two reasons that may explain the weakening Aussie dollar. The first is the interest rate differential between Australia and some other countries. The RBA cash rate is currently 4.10%. In the US the Fed Funds rate is 5.5%. Investor funds tend to flow to countries with higher interest rates which increases demand for those currencies.

The other factor is continued weakness in the Chinese economy which may impact demand for iron ore and other commodities that make up a large portion of Australian exports. Commodity demand has traditionally impacted the Aussie dollar.

Australian investors with global investments

A weakening Australian dollar is positive for local investors who own overseas investments via direct shares that trade on global exchanges and managed products like funds and ETFs. Returns from global investments have two components. The price movements of the underlying holdings and changes in the exchange rate between the Australian dollar and the local currency of the investment.

On the 13th of July the Aussie dollar was $0.69 to one US dollar. In a little over a month the Aussie dollar dropped to $0.64 to one US dollar on the 19th of August. If you purchased shares in Amazon (NAS: AMZN) which trades on the Nasdaq in the US the share price performance over that short period has basically been flat. On July 13th Amazon was trading at $134.04. On the 18th of August the shares closed at $133.22.

If 100 shares were purchased on the 13th of July it would have cost investors $13,404. Upon selling them on the 18th of August proceeds would have been $13,322. A loss of $82 or .80%.

As an Australian investor currency would also come into play. To obtain the $13,404 US needed to buy shares in the online retailer would have taken $19,426 AU at the exchange rate on the 13th of July. When the proceeds of the sale of $13,322 US was converted back to Australian dollars at the 18th of August exchange rate it would result in proceeds of $20,943. The impact of currency movements has turned a slight loss in US dollars into a gain of $1,517 or 7.8% in Aussie dollars.

We can also see the impact of currency movements on the returns of global investments by exploring the differences between hedged and un-hedged ETFs and funds. A hedged ETF and fund removes the impact of currency movements through the use of futures contracts. There are minimal fee differences between a hedged and unhedged ETF or fund which accounts for the costs of hedging.

For instance, the iShares S&P 500 ETF (ASX: IVV) tracks the returns of the 500 largest companies in the US. The iShares S&P 500 ETF AUD hedged ETF (ASX: IHVV) tracks the same index but removes the impact of currency movements. Over the past 5 years IVV returned 14.25% annually while IHVV returned 9.37%. The higher returns of the unhedged version are a result of the Aussie dollar weakening against the US dollar over the past 5 years. For more on hedging please see this article.

The impact on Australian companies

A weaker Australian dollar has several implications for Australian companies. And many companies will be impacted in multiple ways with positive and negative effects counteracting each other.

The first impact is that exports may be more competitive given a weaker Australian dollar. If an export is priced in Australian dollars, a weaker currency means the product will be cheaper than alternatives in a foreign market. That can increase demand. However, may of Australia’s largest exports are commodities that are priced in US dollars.

That is not all bad. And it brings us to the next impact of a weakening currency. Profits made overseas are worth more in Australian dollar terms. That benefits any Australian company with international operations and the commodity producers selling in US dollars.

Other companies face increasing costs from a weakening dollar. Companies that purchase inputs from overseas will see costs rise. It is a difficult environment to pass along these extra costs to consumers given the inflation we are already facing. Demand could also drop for companies that are selling global products in Australia. Consumers may search for cheaper alternatives.

One further complicating factor. Many companies hedge currency risk. This can involve hedging the impact of currency changes on revenue or currency driven price changes for inputs. That might delay the positive or negative impact from currency changes.

Economic impact of a weakening Aussie dollar

I’ve already covered the impact of a weakening dollar on Australian companies. The fortunes of individual companies will have an economic impact through employment and investment. But there is another impact from a weakening Aussie dollar.

Changes in currency effect the relative costs of imports and exports. A weakening Aussie dollar makes exports cheaper for foreign buyers. It also makes the costs of imported items higher for Australians. All things being equal a weakening Australian dollar is inflationary as consumer and companies pay higher prices for imported items.

This may put more pressure on the RBA to continue to raise interest rates to control inflation. At the very least it may delay future interest rate cuts which mean prolonged pressure on homeowners already struggling under the weight of higher interest rates.

What are the options for investors?

Before getting into how investors can respond to a fall in the Australian dollar it is important to state that continually adjusting your portfolio based on market conditions is not a recipe for success. Constant adjustments to a portfolio lead to poor tax outcomes and increase transaction costs. And that is assuming that the future predictions come to fruition. Both individuals and professional investors have poor track records of predicting short-term market movements.

It is far better to set a long-term strategy that is based on achieving individual goals and consistently following a plan. If personal circumstances dictate a strategy where currency is hedged - stick to it. Vice versa if an unhedged strategy is the best way to achieve your goals.

However, it is important to acknowledge that the Aussie dollar and the US dollar over the past 8 years have been trading in a bit of a pattern. The Aussie dollar has stayed in a range between around 80 cents at a high and around 60 cents at a low. If we go back over a 20 year period the low end of the trading range was similar. The high end peaked with $1.10 Aussie to $1 US in 2011.

This of course doesn’t mean the Aussie dollar won’t continue to get cheaper. But we can characterise an Aussie dollar at 60 cents to a US dollar as historically cheap. Am I suggesting that you should liquidate your portfolio and starting trading currency? Of course not. But if your investment strategy calls for partially hedging global equities than perhaps now is a time to direct more funds into the hedged portion of your portfolio in anticipation that the Aussie dollar will eventually recover.

The strong returns from the US market and the weakening Aussie dollar means that global share investments may be overweight in your portfolio. Investors who are saving and investing may want to direct new funds away from global unhedged shares to rebalance their portfolio.

None of these approaches involve deviating from a long-term investment strategy. They are simply acknowledging that historically the Aussie dollar bounced back from these levels. There are countless influences on the performance of a portfolio and individual companies. Currency has one of the largest impacts for global investing.

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