Aussie dollar direction is key to investing down under

Australian dollar AUD investing ASX

One of the most vital things Australian investors need to get a handle on is which direction the Australian dollar is heading.

That is particularly the case when the Australian market is volatile and falling, which is certainly the case after President Trump’s tariffs on steel and aluminium imports sliced almost one per cent off the ASX 200 on Friday before it firmed a little to close down 0.6 per cent.

Overall, in a very choppy month the S&P 500 index ended February with a decline of 3.9 per cent while the ASX 200 was down a more modest 0.4 per cent, which is probably to be expected given the S&P 500 rose much more strongly than Australian shares.

When you really think about it, the strength or otherwise of the Aussie dollar feeds into almost every investment decision you make, even for passive investors.

To look at just a couple of examples, what percentage of your risk assets should be invested offshore and what percentage in Australia?

We are a tiny part of world markets so to diversify your investments by currency, industry and geography makes good logical sense – but in a shorter term sense investing offshore makes a lot more sense if the Australian dollar is about to fall and a lot less if it about to rise.

Then if we look at commodity prices which are particularly important for the Australian economy and market, virtually everything from oil to iron ore is priced in US dollars.

So if commodity prices are rising but the Australian dollar is as well (which often happens), the effect of those rising prices can be muted in Australian dollar terms.

The direction of the Australian dollar has rarely been as heavily debated as it is at the moment as the world begins to emerge from the post-GFC era of extremely loose monetary policy and negligible interest rates and begins to normalise.

So what are some of the arguments for where the Australian dollar is heading?

The Bear case for the dollar

Investors who believe the Australian dollar will fall heavily this year – an option which favours investing offshore now – cite a number of trends to support their view.

The most important is the emergence of a significant interest rate differential opening up between Australia and the US.

Dollar bears say Australia’s Reserve Bank has made it clear that it does not see any interest rate rises in the near future – a very stark contrast to the US which appears set to have three and perhaps four official interest rate rises this year.

With the risk free rate of return rising in the US and perhaps staying static in Australia, that is likely to tip the scales in the favour of the US currency appreciating versus the Aussie.

Secondly, the dollar bears think that Australia’s terms of trade will continue to decline, putting more downward pressure on the dollar.

Then there is the dramatic increase in market volatility and risk, which also weigh on the Aussie, given that it tends to perform best at times of low risk and high optimism.

Finally, Australian inflation has been stubbornly below the Reserve Bank target and property prices are falling, both of which will act to dissuade the Reserve Bank from raising interest rates for quite some time.

The Bull case for the dollar

The major reason many hedge funds give for their leveraged long positions on the Australian dollar is that world economic growth is rising, something which plays to Australia’s strengths.

Even the International Monetary Fund has predicted a global economic expansion of 3.9 per cent for the next couple of years, which would be the fastest we have seen since 2011.

While that might cause some volatility such as we have seen in the past week, it should be positive for markets and particularly for the Australian dollar.

China plays a really big part in this equation – if the world’s second biggest economy continues to grow strongly then it will continue to suck in more large chunks of Western Australia in the form of iron ore and many other commodities such as coal that Australia produces as well.

A strong and growing mining sector should also feed through many other sectors of the Australian economy, such as transport, property and most industrial and retail companies.

The importance of China is seen in some Macquarie research which showed that the dollar could be approaching US85c by the end of 2019 should Australia’s terms of trade gain by ten per cent but fall to the low US70’s if the terms of trade fell by 20 per cent.

Dollar bulls also maintain that having US interest rates above Australian rates is not nearly as important as where commodity prices and particularly Chinese demand heads.

Profit season finishes well but far from spectacular

Whatever your opinion on the direction for the Australian dollar – and these opinions are particularly polarised at the moment – the final trickle of profit results for ASX companies in the past week finalised a picture of a solid but not spectacular profit season.

CommSec analysis showed a record 94 per cent of half year reporting companies produced a profit, well above the long term average of 87 per cent.

That is not quite as exciting as it looks because aggregate profits aren’t soaring, they were actually down 1.5 per cent on a year ago.

If we removed BHP, CBA and Telstra from that analysis, profits were up by 3.2 per cent on a year ago but even so that is hardly a booming result.

The reason isn’t too hard to find; while revenues were up 6.9 per cent, costs were up even more at 8.2 per cent due to rising energy bills and other inputs.

Looking for broad themes through the results, many companies continued to stockpile cash and reinvest in their business.

Department stores produced poor results although specialty retailers fared better but telecom and technology companies also struggled.

Agricultural companies were generally strong on positive trading results from Asia and home construction and related companies also did well, with transport and infrastructure companies outperforming.

Lithium remains a mystery

The lithium market remains an enticing mystery with a report from Morgan Stanley this week predicting that electric car sales will be disappointing and that lithium prices have run too hard.

That concept of lithium stockpiles rather than short supplies got some traction among investors in lithium stocks but on the other side of the equation, Pilbara Minerals’ (ASX: PLS) $80 million lithium concentrate offtake deal with South Korea’s POSCO pushed hard in the opposite direction.

Small cap stocks this week

Looking at the past week, several market themes conspired to affect Australian shares, with several small cap names in amongst the headlines.

First Graphene (ASX: FGR)

One of the first Australian companies to pursue graphene commercialisation has now kicked off production at its commercial graphene facility in Western Australia, which the company states is a “significant milestone” for the global graphene industry.

Given its stellar molecular properties and extremely opportunistic range of industrial applications, graphene has captured the attentions of resource companies, industrial producers, consumers and investors alike.

To assist with global market expansion, First Graphene is shipping trial parcels of its product for testing in a range of applications including battery, concrete, fire retardants, paints and coatings and polymers.

In addition, the company says it is in negotiations with potential customers across Australia, Europe and the United States.

Central Petroleum (ASX: CTP)

Central Petroleum reaffirmed its ambitious intentions in the natural gas space, by announcing a joint-venture deal with Incitec Pivot, Australia’s largest supplier of fertilizers and other industrial products.

From a size point of view, the two companies are polar opposites, but by forming a 50:50 joint-venture partnership, Incitec Pivot and Central Petroleum plan to develop a natural gas bearing project in Queensland to support of the long-term viability of Incitec’s Gibson Island fertiliser facility in Queensland.

The two parties have signed a Memorandum of Understanding and intend to conduct appraisal and drilling if its bid is accepted by the Queensland Government.

According to Incitec Pivot, as long as proven reserves are confirmed and acreage is developed further, first gas production can be expected around 2022.

In addition to its Queensland plans, Central Petroleum is making progress on further natural gas assets in the Northern Territories.

This week saw the ACCC provide firm support for Central Petroleum to conduct “joint gas marketing arrangements” with Macquarie Mereenie, a resources company owned by Macquarie Group.

During a period of joint marketing, Central and Macquarie intend to develop new reserves at Mereenie, estimated at between 110-185 petajoules (PJ), by drilling two new wells.

The two companies plan to develop a significant oil and gas field located in the Amadeus basin in the NT, with an imminent “joint-venture meeting” now expected to decide the drilling of its latest prospect (West Mereenie-26).

Patrys (ASX: PAB)

Patrys received positive trial results for PAT‐DX1, its current treatment of various brain cancers, and thinks it can make sufficient progress to develop wider applications across other malignancies such as gliomas, melanomas, prostate, breast, pancreatic and ovarian cancers.

In a range of pre‐clinical cancer models, PAT‐DX1 has shown significant ability to kill cancer cells in cell models, human tumour explants and xenograft models. PAT‐DX1 has also been shown to work synergistically with the approved PARP inhibitor, olaparib.

If successful, Patrys will market PAT-DX1 as a means of treating cancerous tumours more effectively compared to existing treatments.

DigitalX (ASX: DCC)

DigitalX wooed market analysts and investors this week by announcing a US$8 million profit in the first six months of 2017, on the back of advisory services and raising over US$300 million in initial coin offerings (ICOs) for third parties.

The news was a welcome surprise to blockchain and cryptocurrency sceptics that doubted the ability of blockchain-led initiatives to generate strong commercial returns, considering the early-stage status of blockchain-enabled cryptocurrencies.

Managing Director, Leigh Travers said revenues were primarily driven by Blockchain and ICO consulting and advisory fees as well as “gains in the value of digital assets” held by DigitalX.

Quite possibly a veiled reference to DigitalX potentially holding a sizeable number of Bitcoins and/or other cryptocurrencies.

The company was also chosen to be the blockchain advisor for Transcendence Technologies (ASX: TTL) new E-Collate data management and communications platform.

RHS Limited (ASX: RHS)

The rapidly evolving biotechnology sector is firmly in the headlines again as the blitzkrieg rate of US-funded acquisitions continued.

RHS Limited became the latest ASX-listed biotech company to announce its likely takeover by a US peer, with billion-dollar-capped PerkinElmer (NYSE: PKI) offering around $25 million in an all cash deal for RHS (a 100% premium to its publicly-traded price).

Regular readers may cast their minds back to last week when Merck and Viralytics announced a proposed deal that will likely see the US giant acquire Viralytics for around A$502 million — a 160% premium to its market value. Viralytics also receiving a boost from investment bank Morgan Stanley, who is now a substantial holder in the company with around 7.58% holding.

Queensland Bauxite (ASX: QBL)

Turning over a new leaf has probably never meant so much, as it does now for Queensland Bauxite.

The company decided to take a leaf out of a biotech book this week by moving into autoimmune disease treatment through its subsidiary, Medical Cannabis.

Medical Cannabis will provide funding for research on treating, and potentially curing, multiple sclerosis and other autoimmune diseases with medicinal cannabis.

Under the agreement, Medical Cannabis will provide US$3 million over three years to the Research and Development Foundation to fund investigations into treating autoimmune disease symptoms and halting disease progression with medicinal cannabis, initially focussing on multiple sclerosis.

In return, Medical Cannabis will own the rights to any products developed from the study.

King River Copper (ASX: KRC)

Amiable metallurgical results gave King River Copper a shot in the arm this week, as the company closed the week at $0.061 per share, around 10% higher from Monday’s open.

King River reported that metallurgical testing on ore from its Speewah project in WA has achieved a 99.48% pure vanadium pentoxide, thereby raising its potential commercial viability.

Speewah hosts Australia’s largest titanomagnetite and vanadium resource, currently estimated at 4.7 billion tonnes at 0.30% vanadium, 2% titanium and 14.7% iron.

King River wants to reach a purity rate between 99.5-99.9% through a “vanadium concept study” currently being conducted.

In addition, King River has the potential to obtain other valuable material from the same location at Speewah.

In partnership with TWS, King River is looking to obtain a high purity titanium dioxide from Speewah, which would be in addition to the 6.7 million tonne fluorite resource update published last month.

Upcoming IPO

To see the full list of upcoming floats to the ASX visit our IPO page.

Power Asia (ASX: P88)

Led by Executive Director Mr Alan Gao, Power Asia is issuing 45 million shares at a price of $0.20 per share and raising $9 million as part of its ASX listing, to be completed this month.

Spurred on by the strong re-emergence of renewable energy as a commercially viable option, dozens of renewables-focused companies are now flocking to secure a variety of commercial opportunities.

For Power Asia, its focus is squarely on installing solar technologies and advancing efficiencies offered by scalable renewable energy generation.

Power Asia wants to leverage its expertise to make further inroads into commercialising solar energy further afield in Asian countries where it’s addressable client base and level of spare capacity is arguably higher in comparison to markets like Australia.

Pre-listing on the ASX, Power Asia is developing two flagship projects and is confident of embarking on new projects as part of its set of “alliance agreements” with several Chinese state-owned enterprises (SOEs).

Following the signing of its set of Alliance Agreements with Sinohydro, MaSteel and AnSteel, PowerAsia intends to identify specific energy and infrastructure projects in the near-medium term which its partners may elect to participate in on a joint venture basis.

The Week ahead

Reinforcing the message of the influence of interest rates on the Australian dollar, this week’s meeting of the Reserve Bank board on official interest rates will be pivotal.

While no-one is expecting a change of policy or any shift in interest rates, the language of the statement will be examined very closely to see if there is any shift in the language towards a rate rise or, much less likely, a future rate cut.

Other than the central bank, the retail sales numbers for January should tell the story of just how successfully department stores cleared out their unsold Christmas inventory in the following sales.

    Join Small Caps News

    Get notified of the latest news, interviews and stock alerts.