Friday, January 23, 2009

Let’s be Strategic with the $A

Back in mid-October we wrote in one of our weekly rants that the $A was being punished for the sins of others and when the dust settles, the $A will steady in the low 70USc’s. Our view was that our economy is fundamentally sound and that our favorable exposure to China will help us weather the storm.

Well, since then the $A did briefly touch 72USc (in the data vacuum over Christmas) but we are now back in the mid 60USc’s and we look like ‘again’ seriously testing recent lows just above 60USc.Like the pattern in grain prices, trading in the $A so far this year provides a snap-shot of what to expect for most of 2009. The $A has been struggling under the weight of data suggesting that economies around the world – particularly the US – are spiraling out of control.

The data makes you cringe. Nov US industrial output figures were down 5.5%. Manufacturing production is down 7.3%, shrinking at its fastest pace since the 1980’s recession. Similarly, in the Euro area industrial output has contracted 5.7% – its slowest pace since the early 1990’s. Data on industrial orders points to this trend continuing well into the March quarter.

US employment has fallen by more than 500,000 for the second consecutive month (423,000 back in October) and the unemployment rate has jumped to 7.2%, a level not seen since January 1993. The 2.6 million jobs lost in 2008 is the most since 1945.Put bluntly, the hard economic data is very ugly and expected to get uglier; with reports of production cuts, job cuts, expense reviews and the conservation of cash by large-scale companies dominating the news wires. With this as a backdrop, the $A will be prone to bouts of risk aversion for at least the first part of the year. We also have some monetary easing to do ourselves as our rates are still too high.And there is no doubt that our white knight China is slowing with many experts tipping growth will dip below 7% (which is almost a recession) over the next couple of quarters. Profits fell almost 30% in Sept-Nov, the first such contraction since 2002. If the data continues to disappoint this will exert downward pressure on commodity prices and commodity-linked currencies such as the $A (potentially pushing the $A below 60USc).

But by mid-year, measures taken by the US Fed to boost the money supply, combined with the commencement of spending from the massive fiscal stimulus packages introduced around the world, should help steady financial markets and improve consumer confidence. With policymakers firmly focused on rejuvenating financial markets and boosting economic activity, we believe that risk appetite will eventually recover later in 2009 – but the chances of another bout of risk aversion earlier in the year seems increasingly likely. Europe may need to keep slashing rates closer to zero over coming months.

As risk aversion improves, the impact of monetary easing in the US and Europe will weaken these currencies and see a return of buying for ‘riskier’ high-yielding currencies, leading to a mild to strong recovery from mid-year. This is provided these stimulus packages are successful and that Chinese demand holds up.Strategy: The $A should start recovering at the same time we think grain prices will start to trek higher i.e., we expect movements in the $A and grain prices to maintain their strong correlation in 2009.

So how do we profit from this view? We buy $A/$US call options on dips in the forward $A below 60USc.

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