Summary of events
Popular uprisings demanding democratic reforms that have already toppled autocratic regimes in Tunisia and Egypt now threaten vast swathes of the Middle East and parts of Africa. While Libya is currently garnering most attention, Algeria, Jordan, Iran, Bahrain, Yemen have all recently experienced mass demonstrations. To a lesser extent, unrest has also emanated out of Morocco, Syria and Saudi Arabia. Many of these nations are large oil producers.
It has been estimated that the Middle East holds around two thirds of the world's proven oil reserves and almost half of its gas reserves. Since the start of the industrial revolution our reliance on oil as a source of energy has proliferated. From an economic perspective the importance of oil cannot be understated. To highlight how important oil is to the global economy we need look no further than the 1970's.
In 1973 the Yom Kippur War triggered a sharp increase in the oil price that led to the global recession of 1974-75 (and a sharp slide on global equity markets). As oil is a major input of production, this recession was notable because it was characterised by high unemployment and high inflation (what is known as 'stagflation'). In a typical recession high unemployment is a normal outcome but the lack of consumer demand also typically leads to lower inflation. In a stagflationary environment though, higher input prices coexist with high unemployment, often for an extended period of time, before supply/demand fundamentals eventually adjust (in 1975 this occurred when oil supplies were eventually restored to some degree of normality). Several years later the Iranian revolution caused another stagflationary outcome that triggered another global recession (and share price meltdown).
It is for these reasons (oil security aids economic security) that US foreign policy has always had a keen interest in the stability of the region, including backing some autocratic regimes that assisted in this stability (and by corollary, sometimes at the expense of compromising the best interests of the citizens of these countries).
So as events in the Middle East unfold, we watch from afar with much admiration for those willing to put their lives on the line for a better life, but also with some trepidation. Regime change is rarely a smooth transition. Political and ethnic divisiveness often leads to significant unrest and, in a worst case scenario, civil war.
While it is impossible to predict the actual outcomes, there is at least a reasonable probability that in the short term oil prices may continue to rise, even if supply is not interrupted to any greater extent.
Should the situation deteriorate in one of the key oil reserve countries (see list below), then there is a real risk that supply would be threatened in which case the likelihood of even higher prices would follow. The resultant cost push inflation that could eventuate would present a real threat to the global recovery. It must be said that the global recovery remains somewhat fragile, huge debt burdens remain unaddressed in many developed nations, and so the ability of the world to absorb an oil price shock is lessened.
In the short term it is advisable to retain some cash on the sidelines in your portfolio, particularly for more active investors, just in case events do deteriorate.
Predicting the Aussie Dollar
As the Australian dollar (AUD$) has soared relative to the US Dollar and the Trade Weighted Index (a basket of currencies) over the last 12 or so months we have fielded many questions about its future direction. Historically, we have adopted a conservative approach to exchange rate movements by hedging at least 50% of our international share exposure to minimise the impact of exchange rates. Certainly this strategy has worked in our favour in recent times as international equity investments with currency hedging in place have significantly outperformed those without. Before we consider the future direction of the AUD$, it is useful to have some understanding on how exchange rates function.
Understanding exchange rates
An exchange rate is designed to adhere to the Law of One Price, which is that identical goods should sell for the same price in 2 different countries at the same time. When countries use different currencies, the exchange rate adjusts to ensure that the Law of One Price prevails. This exchange rate adjustment is referred to as Purchasing Power Parity (PPP).
A toaster in the United States sells for $100. The identical toaster sells for $130 in Australia. If exchange rates were in equilibrium, 1 US dollar would buy $1.30 Australian dollars. Putting it another way, 1 Australian dollar would buy $0.769 US dollars.
If the prevailing exchange rates make it cheaper to buy the toaster overseas than in Australia, then theoretically the Australian dollar is overvalued. Under these circumstances, an entrepreneur may decide to take advantage of the pricing arbitrage by importing the toasters into Australia. In theory this would have two effects. Firstly, the laws of demand and supply may dictate that the price in the United States for toasters may rise (because there is greater demand for them). Secondly, the laws of demand and supply also work in currency markets. The Australian importer uses his Australian dollars to purchase US dollars to fund the toaster purchases. This puts downward pressure on the Australian dollar and upwards pressure on the US dollar. Both of these effects should correct the Australian dollar overvaluation.
Is the Australian Dollar Overvalued?
Armed with the basic tenets of exchange rate theory, we can now use real world examples to calculate whether or not the Australian dollar is under or overvalued. One product that has been infamously used in the Economist magazine for many years now to measure exchange rate differentials has been the 'Big Mac' index. As the name implies, it is based on the price of a Big Mac purchased at McDonalds restaurants around the world.
Price of Big Mac in the United States as at 8 March 2011:
Price of Big Mac in Australia as at 8 March 2011: AUD$4.35
Exchange rate as at 8 March 2011: USD$1 = AUD$0.9906.
If we convert both prices into USD$, then:
Price of Big Mac in the United States as at 8 March 2011: USD$3.73
Price of Big Mac in Australia as at 8 March 2011: USD$4.39
This means that the price of a Big Mac in Australia costs 17.6% more than in the United States. All other things being equal, it could be said that the AUD$ is overvalued by 17.6%.
At this stage you are probably starting to see some of the pitfalls of the theory. How does the exchange rate adequately take into account differing costs of production (different labour, raw materials and transport costs), different profit margins and different markets (one is substantially more populous and competitive than the other)? The answer is that it can't necessarily do this with complete accuracy. In theory the price of a Big Mac in Australia should be higher than in the United States to reflect the smaller market and lower volumes.
Using one product of course is also not representative of the entire market. The accuracy doesn't necessarily improve with a basket of goods either. The reason is that the concept of exchange rate equilibrium is far more complex than it appears. There are many other factors at play rather than the price of goods alone.
Key factors which influence exchange rates
Some of the key factors that influence exchange rate movements are as follows:
Interest rate differentials: Higher interest rates in Australia relative to the United States will attract offshore investors to Australia. The additional demand for Australian dollars pushes up the price of the currency. US 12 month treasury bills are currently returning 0.23% while Australian 12 month bond rates are returning 4.86%. This is a significant differential and is an important factor in the strength of the Australian dollar relative to the US dollar. The practice of switching investments from low interest rate countries to higher interest rate countries is known as the "carry trade". It must be said that the "carry trade" strategy is a risky practice as any gains from additional interest earned can be rapidly eroded by adverse exchange rate movements.
Inflationary expectations: An increase in inflationary expectations has differing impacts on currency. Firstly, it tends to increase interest rates which factor in the additional inflation premium into the cost of lending money. An increase in interest rates (all other things being equal) will tend to lift the AUD$. Secondly, inflation erodes the real purchasing power of money and so can also have a corresponding dampening effect on the AUD$.
Economic growth expectations: Growth relativities also impact the value of the AUD$. If growth in Australia is forecast to be stronger than in the United States then capital will tend to flow to the country with the better prospects and increase the value of its dollar.
Commodity Prices: In recent years commodity prices have had a material correlation with exchange rate movements. Demand from China (in particular) for our resources has created upward pressure on commodity prices. Large purchases of coal and iron ore has translated into significant demand for the AUD$.
Debt and deficits: As a general rule, countries with large debt positions tend to rely, in part, on offshore lenders. While the Australian government in part relies on offshore investors to fund its deficits, it should also be remembered that business, in particular the banks, also rely heavily on offshore funding to finance operations. Borrowing money from offshore reduces demand for AUD$ all other things being equal.
Quantitative Easing: Increasing the money supply by way of printing money (or via practices that essentially have the same effect) increases the supply of money without necessarily any corresponding increase in demand. Such strategies typically put downward pressure on currencies. Quantitative Easing measures undertaken in the United States have depressed the US dollar.
Our view on the future direction of the AUD$
A myriad of factors affect exchange rates. Movements are often difficult to predict because many of the factors that impact upon exchange rates are based on future expectations. With this disclaimer in mind, our view on the future direction of the AUD$ is as follows:
- In the short run we would expect the AUD$ to remain firm. If the pace of the recovery in the US continues to improve then perhaps towards the end of this year interest rates in the US may begin to rise off their extraordinarily low base. This would act to narrow the interest rate differential and cause the AUD$ to weaken somewhat against the USD$.
- Australia has a relatively narrow manufacturing base which means that we remain particularly vulnerable to any fall in commodity prices. A sharp fall in commodity prices would inevitably result in a fall in the AUD$. In the short term, we do not see this as a likely outcome.
- The size of the US Government's debt means that its dollar is likely to be under pressure for an extended period of time. This impact though is already factored, at least in part, into exchange rate markets which is why we would still expect the USD$ to strengthen against the AUD$ if the US economy continues to slowly improve.
- Given that our base case scenario is for the AUD$ to potentially fall somewhat towards the end of this calendar year, we would expect this to translate into improved share prices for companies with significant exposure to offshore earnings (all other things being equal).
- Similarly, it may also be a reasonable time to obtain some exposure to international equity investments that are unhedged for currency risk. We can assist in this selection process should that be desired.
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