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Despite a likely improvement in the global economic outlook in 2020, this note explains why the $A may well slip further next year – due to an unwinding of the recent iron-ore price boom, $US strength, and local quantitative easing measures by the Reserve Bank. My call is the $A will reach US62c by end-2020, a fall of around 10% from current levels.
Key drivers of the $A should remain negative forces in 2020
Being so widely and efficiently traded, foreign currencies are one of the hardest financial prices to forecast accurately, especially over the short term. That said, the $A has broadly followed certain key fundamental variables over recent decades, such as interest rate differentials and commodity prices. As might be expected, trends in the $US help determine trends in the $A – when the $US is strong globally, the $A tends to be weak versus the $US, and vice versa.
My $A valuation model includes these three key variables. As seen in the chart below, these variables have managed to explain trends in the $A reasonably well over time. Indeed, as evident here and here, previous updates of my model have been broadly correct in forecasting further declines in the $A in recent years.
As can be seen below, based on my projections for relative interest rates, commodity prices and the $US, the model currently predicts a decline in the $A to around US62c by end-2020.
Specifically, my forecast assumes the RBA cuts the official cash rate to 0.5% by February 2020, and holds the official cash rate at that level for the remainder of the year. The US Federal Reserve is expected to hold the Fed funds rate steady This implies a further narrowing in short-term interest rate differentials. A further difficult to quantify factor – and hence not factored into the model – is the RBA’s likely quantitative easing policies (which should at least entail buying up government bonds). This is expected to place further downward pressure on the $A.
Perhaps even more important, in terms of model sensitivity, is my forecast for a further decline in iron-ore prices to around $US55/tonne by end-2020. This reflects an expectation of some rebound in Brazilian iron-ore supply following the dam tragedies last year, and less need for Chinese stimulus of steel-intensive infrastructure projects once the trade war ends.
Due to growing risks to the US economy, my view is predicated on President Trump not only agreeing to a ‘phase 1’ deal with China, but also refraining from re-escalating trade tensions at least until after the November 2020 Presidential election.
Last but not least, I anticipate further strength in the $US, due to the fact the US economy is likely to remain relatively strong and an attractive investment destination compared to weaker economies such as Japan and Europe.
Of course, it’s important to remember that past performance is not a reliable indicator of future performance. Whilst every effort has been taken to ensure the assumptions on which the forecasts in this article are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.
RBA will rejoice at a weaker $A
Due to strong domestic competitive pressures, a weaker $A is not expected to materially increase the local rate of consumer price inflation. That said, the $A will help lift inflation at the margin, as well as provide some boost to the economy through improved international competitiveness. Indeed, in its latest Statement on Monetary Policy, the RBA revealed internal modelling which suggested that a 5% decline in the $A would boost economic growth by 0.5% over two to three years. My forecast implies a 10% decline in the $A, at least against the $US.
A weaker $A has several investment implications. For starters, a weaker $A can add to the returns from unhedged global equity exposures, such as the NASDAQ-100 ETF (ASX Code: NDQ). That’s because a weaker $A boosts the $A value of foreign currency exposure, such as holding unhedged international shares.
Other equity funds offering unhedged $US exposure include the FTSE RAFI U.S. 1000 ETF (ASX: QUS), and the S&P 500 Yield Maximiser Fund (managed fund) (ASX: UMAX).
Another way to more directly gain exposure to a weaker $A thematic is via foreign currency exchange traded products. The BetaShares US Dollar ETF (ASX: USD), for example, simply holds $US as its underlying asset – thereby providing direct exposure to movements in the $A/$US exchange rate, and rising in value as the $A declines against the $US (conversely, the value of units in the fund will go down if the $A goes up against the $US).
The BetaShares Strong $US Fund (ASX Code: YANK), moreover, provides magnified exposure to the $A through gearing, such that a 1% rise in the $US versus the $A can be expected to generate a return of between 2 to 2.5%, and vice versa. Please note that gearing magnifies gains and losses and may not be a suitable strategy for all investors. Investors should be willing to accept higher levels of investment volatility and potentially large moves (both up and down) in the value of their investment.