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Dollar driving investment

The world of behavioural economics is breaking down old misconceptions. Economists no longer believe consumers are rational agents maximising their utility. Instead it’s recognised that consumers are driven by multiple considerations, some economic, some not. Some logical, some not. By extension, this also applies to investors.

In fact functioning markets demand a degree of irrationality, or at least ignorance. Although individual circumstances feed into investment decisions, if all actions were purely logical markets would quickly become very lopsided. A vast majority would be on the bid, or the offer, and liquidity would dry up, or market volatility increase enormously.

This makes investment decisions more difficult. However there is a short cut. All of the factors driving a market at a given moment, whether logical or illogical, are reflected in a single number; the price. The current price trend shows how the balance of those factors is shifting. Looking at the two in conjunction gives valuable clues to investors.

The rationale for studying price action dates back to Aristotle. He is credited with first acknowledging the “wisdom of crowds”. Statistician Francis Galton (Darwin’s cousin) performed a famous experiment in 1906, demonstrating that in a county fair competition the average of more than 800 guesses at the weight of a dressed steer was closer to the mark than the winning entry. James Surowiecki published on the topic in 2005, and scholars at MIT and Princeton (among many others) are currently working on refining crowd based analysis techniques.

Investors don’t need an economics lab to distil the wisdom of crowds. Essentially, charts track the distilled wisdom of the crowd. Professional traders and investors benefit from studying the changes in market (crowd) thinking over time. And the world’s biggest market is speaking right now.

Europe as a whole and the USA are two of the three largest economies in the world. EUR/USD is the biggest market in the world. Daily turnover averages around $2 trillion US dollars a day. The fluctuations in this currency pair reflect shifting market thinking about the relative outlooks for these two major regions.

As this is the price of Euros expressed in US dollars, up moves points to an improving European situation. When EUR/USD goes down, the US dollar is strengthening.

For most of 2018 the pair traded sideways in a range between 1.2150 and 1.2500. A few weeks ago this range broke as the US dollar responded to stronger growth and inflation numbers. Since the breakdown through 1.2150 a trend has formed, indicating the US dollar will continue to strengthen. What does this mean for investors?

The first reaction of many investors is to consider the impact on the Australian dollar. As the USD rises, AUD falls. Many investors will look for the usual suspects – locally listed companies with international earnings. The list is fairly well exposed. CSL, Cochlear, James Hardie, Boral, Computershare and so on.

However the impact of a lower AUD on the economy might mean investors should turn to domesticate earners, particularly given stretched valuations in the overseas earners.

Currency markets are the transmission channels between economies. A falling AUD means higher levels of US demand find their way to cheaper Australian goods and services. This in turn stimulates the local economy, bringing higher growth and inflation. Given lower inflation and wages growth are currently disturbing elements of the economy this would be a welcome effect.

The strengthening USD is potentially a mixed blessing. Commodities are generally priced in USD. A strengthening USD knocks agricultural and mining commodities around, all else being equal (although it never is).

Nonetheless a rising USD is on balance good news for the Australian economy. If the current downward trend in EUR/USD continues it should see an improving outlook for the Australian economy. This could translate to fresh ten year highs for local shares, and push the Australia 200 index through the 6,150 high struck in January. Investors are on currency watch notice.

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