In this post-2008 crisis world, global capital flows violently from asset class to asset class and country to country, seeking opportunity and safety in equal turns.
In doing so, capital flows through currencies and into assets denominated in that currency, whether they be bonds, land, property, shares or bank deposits.
Do you remember back in the late 1990s when international shares were all the rage? Back then, Aussie investors benefitted from rising stock markets AND a falling Australian dollar.
The combination produced years of double-digit returns and made international shares the favoured asset class.
But in the past decade, the tide has turned. Thanks to a secular resources boom, the Australian dollar has gone from one of the weakest to one of the strongest major currencies in the world. The strong domestic currency, combined with weak global markets since the dot com crash, has led to international shares being the worst performing asset class over the past decade.
How Strong is the Australian Dollar?
How strong has the Australian dollar been? As you can see in the chart below, the Trade Weighted Index (TWI), also known as a country’s ‘effective exchange rate’, illustrates the Aussie dollar’s decade long strength.
The TWI is a measure of a currency’s purchasing power relative to its trading partners. The terms of trade (the value of exports relative to imports) are a major driver of the nominal TWI.
A nations’ productivity also plays a role in determining relative currency strength. The real TWI adjusts the nominal value by taking into account the differences in consumer price inflation between Australia and its trading partners.
So what is the chart telling you? Well, in simple terms its saying the purchasing power of the Australian dollar hasn’t been as strong (in nominal terms) since the early 1980s. And back then the currency was on its way down following the float of the dollar in 1983.
In real terms, the Australian dollar hasn’t seen such strength since the mid-1970s. This coincided with Australia’s last great commodity boom, which fed Japan’s industrialisation. This time, it’s China’s industrialisation that’s behind the surging TWI.
There’s also another way to interpret the chart.
Cheap Overseas Holidays, Cheap Overseas Assets
The steep rise from 2002 reflects the flow of global capital into Australian dollar denominated assets. Put yourself in the shoes of a US fund manager in the early 2000s.
You see the rise of China in the decade ahead and view Australia as ideally placed to benefit. At the time, $US1 dollar buys nearly $2 Aussie dollars. In US dollar terms then, Aussie assets are dirt cheap.
So it makes sense to invest capital here. Over the past decade, all asset classes have increased in value…property, shares and bonds have all appreciated. And if you’re a foreign investor, you can add a significant currency benefit to that return.
In short, the past decade has been very good for foreigners investing in Australia. They’ve had the benefit of rising asset prices plus a currency tailwind…the best of both worlds.
But that was last decade. What do you think the next decade holds?
Investing is all about probabilities and foresight. So ask yourself, what is the probability of the Australian dollar continuing to move higher from here? Australia’s terms of trade are declining, and our productivity performance is terrible.
The fundamentals for further gains just aren’t there. That doesn’t mean panicked capital flows won’t continue to support the Aussie in the short term.
But I think we’re very close to a secular change in currency values which would lead to particular investment consequences. If I’m right the trade weighted index will turn down and revert to ‘more normal’ levels.
That being the case, wouldn’t it make sense to use the current strong purchasing power of the Aussie to diversify into investments where asset prices are weak but could recover soon? I think it would.
Editor, Sound Money. Sound Investments.
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Written by Greg Canavan
Greg Canavan is a feature Editor at The Daily Reckoning Australia and is the foremost authority for retail investors on value investing in Australia.
He is also the author of Sound Money. Sound Investments (SMSI). An investment publication designed to help investors profit from companies and stocks that are undervalued on the market.
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