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Australian dollar could protect portfolios if markets drop

Scott Haslem  |  09 Mar 2018Text size  Decrease  Increase  |  
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With February’s market drop still fresh in investors’ mind, the good news is that the Australian dollar could help protect local portfolios against a correction in offshore equity markets by providing a natural hedge against an equities sell-off.

That’s because a falling Australian dollar boosts returns from unhedged international investments when those assets are converted into local currency. So if, for example, the Australian dollar falls by 10 per cent against the US dollar, the value of US equity investments would rise by 10 per cent when converted back into local currency.

Currency depreciation can, therefore, represent gains on portfolios.

Typically, the Australian dollar is pro-cyclical, otherwise known as a ‘risk-on’ currency. That is, the local currency tends to rise when global equity markets are rising and fall when markets drop.

Since 2005, the Australian dollar has had a positive correlation with the US equity market over 70 per cent of the time.

The behaviour of the exchange rate during the recent US-led equity correction confirms this relationship. The Australian dollar fell by around 4 per cent against the US dollar when markets fell in early February, suggesting the Australian dollar still retains a valuable role as a hedge against an unexpected drop in equity markets.

For this reason, the Australian dollar is a useful tool for diversifying portfolio risk. To the extent you have offshore share investments denominated in other currencies such as the US dollar or euro, and the Australian dollar depreciates, you gain a little bit back on your unhedged international equity exposures, which helps to offset any losses in your equity allocation if offshore markets fall.

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Australian dollar could drift lower

Several factors could push the local currency lower this year. Interest rate hikes from the US Federal Reserve, significant investment flows to the US and continued strong data there should provide the US dollar with continued support.

At the same time, the combination of weaker Chinese growth, easing commodity prices and steady interest rates here could all combine to push the Australian dollar towards US0.70.

Although interest rate rises in the US last year put little downward pressure on the local currency, three or possibly four more US rate increases this year could tell a different story. With the Reserve Bank of Australia likely to keep interest rates on hold until at least until the fourth quarter of 2018, any US rate rise will chip away at the Australian dollar’s yield advantage and therefore its value.

Indeed, Australia’s 10-year bond yield is now trading below that of the US, which suggests investment flows will not be in the local economy’s favour.

Forecasts for the Australian dollar by the year’s end range from US$0.72 to US$0.85 so there is some variation among economists. While it has been relatively sticky around US$0.80 in recent months, we expect the exchange rate to head lower towards US$0.75 to US$0.77, around the middle of its recent US$0.70 to US$0.80 range.

Offshore equity gains likely to outperform

Despite recent market corrections, we remain cautiously engaged with risk assets, being overweight global equities where we see stronger momentum in economic data and earnings growth than in the Australian market. Recent fourth-quarter GDP data highlight the weakness in the Australian economy, which grew just 2.4 per cent year-on-year in the December quarter of 2017, below expectations.

While jobs growth is strong, housing is slowing and low wage growth has muted consumer spending. Reflecting this, Australian company earnings growth is likely to be less buoyant than in offshore markets.

With the Australian dollar expected to remain in its current US$0.70 to US$0.80 range, moves toward the top of this range could therefore be an opportunity to buy international equities. This is particularly true for portfolios that remain under-allocated to off-shore markets and we know that many Australian portfolios are significantly overweight in Australian shares.

We continue to prefer European equities, where we expect euro appreciation against the Australian dollar to further enhance investment returns.

On the other hand, moves toward the bottom of this range could be an opportunity to sell some offshore investments and reposition portfolios that are carrying more offshore equity risk than our strategic portfolios recommend.

Within domestic equities, companies that have significant offshore earnings may also benefit if the Australian dollar were to drift towards US$0.70.  So, alongside their financial advisers, investors need to stay tuned to the level of the Australian dollar and the portfolio benefits it offers when financial markets sell off. 

As another form of protection, we are also increasing portfolio allocations to alternative assets, which remains a key focus given the more mature phase of the economic and equity market cycles.


Scott Haslem is the Chief Investment Officer at Crestone Wealth Management

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