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Macro/FX/Equities Market Research

Updated: Nov 21, 2018

Phoenix Li - Macro/FX/Multi-Asset Strategies Analyst, Justin Lam - Equities Analyst, Chris Jin - Co-VP Education/Research, Jason Sohal - Co-VP Education/Research

Can the Aussie Dollar Go Lower? – Phoenix Li

Among all the major developed country currency pairs, AUD/USD is the worst performer YTD. There are multiple factors contributing to the year-long slide of Aussie dollar, many of which will be discussed in this research report.

Monetary Divergence

As discussed in the previous FX report, the strong USD had a negative impact on the value of emerging market currencies, as well as many developed market currencies. The Aussie dollar is a great example. Due to the strong economic data coming from the U.S. economy, the Fed has raised rates eight times since 2015.

On the Aussie side, the economy is not doing well, where the wage growth and inflation are still uncomfortably low. The stagnant state of the Australian economy has forced the central bank to keep interest rates at a record low of 1.5% for twenty-six straight months. It is expected to hold its cash rate unchanged well into 2019 while the Fed remains on its hiking path with a forecasted 3% policy rate by the end of 2019.

The graph above is a great demonstration of how rate differentials impact the AUD/USD pair. When the policy rates diverge, since the policy rate is the benchmark for all other fixed income products, a divergence in the yields of related fixed income products will also occur. The graph shows the AUD/USD 10-year bond spread, where the spread has been decreasing and going into negative territory. In other words, the current U.S. 10-year treasury is priced at a 3.2% yield, while the Australia 10-year government bond priced at 2.7%. The current spread is -0.5%.

Let’s do a simple calculation.

If trader A longed a U.S. 10-year bond since the beginning of this year and trader B longed an Australia 10-year bond at the same time, trader A would outperform 9.5% against trader B (9% from currency and 0.5% from bond yield differential). People may argue the 9% gain on the currency is not that predicable, but the positive alpha on the bond trade is almost guaranteed. This effect was magnified when many hedge funds executed this carry trade (discussed in the previous FX report as well). The crowd trading effect could keep the yield on U.S. bonds relatively low (higher demand, higher price, lower yield), but still higher than Aussie bonds since the fundamental driver is the policy rate differential. On the other hand, this crowd trading will boost the demand of USD versus AUD. So, it magnifies the upside of USD/AUD. Therefore, magnifying the total return of the trade.

Looking at the current monetary policy agendas from the Australia Central Bank and U.S. Fed, there is no evidence that the rate gap is going to close anytime soon. Such a carry trade strategy will continue potentially for another year. A meaningful rebound of AUD does not seem very likely.

China Slow Down and Trade War

China is the largest trading partner of Australia, which accounts for 30% of total Australian exports. Any negative news about China is negative news for the Aussie dollar. The Chinese slowdown is everywhere on the news, and the transformation from a manufacturing-based economy to a service/technology-based economy is causing some disruptions. With debt issues among state owned enterprises (SOEs) and trade war uncertainty also in the mix, the Chinese economy is not in ideal shape. This impairs the demand for Australian mining products. In addition, the trade war uncertainty also directly imposes headwinds on the Australian exporting activities in general. Uncertainty and future expectation cause more damage than the actual trading numbers.

The third quarter GDP data from China looks decent, which stands at 6.5% YoY. However, the structure of GDP growth has slowed down on the consumer consumption side, which is a negative indicator for sustainable long-term growth. With the PBOC’s intention to inject more money into the market, the consumer sentiment could recover in the medium term, which might provide some support for the Aussie dollar.

From a multi-asset strategy point of view, with the high valuation of the U.S. stock market and decade-long bull market, more asset allocators are leaning toward to taking on some commodity exposure to hedge for a potential market crash. This could be a tailwind for the Aussie dollar. However, from a fundamental point of view, the China slowdown and end of cycle rhetoric definitely hurt on the demand side. This negativity could be partially offset by a lower AUD (cheaper domestic currency benefits exports). With the monolithic Australian economy, the long-term view on AUD is still mixed, if not gloomy.

Equities Market Update (Oct. 15 - 19) – Justin Lam

North American Markets Recap

After mixed news on the economy and on earnings, both Canadian and U.S. equities ended the week slightly higher to end three consecutive weeks of declines. The markets continued with elevated volatility, with a rally on Tuesday being offset by a sell-off on Thursday. Corporate earnings were mostly positive, but investors remained cautious amidst international tensions and rising interest rates.

Weed the North

On Wednesday, October 17, Canada became the first G7 nation to legalize recreational marijuana. Canadian cannabis company stocks have soared in the past year and in the week leading up to legalization. But the stocks have been extremely volatile, with little to show for their high valuations. Cannabis stocks plunged on Wednesday, in a classic case of traders “buying the rumours and selling the news”. Aurora Cannabis (TSE: ACB) fell by 13% at market open while Tilray (NASDAQ: TLRY) fell by 9% before recovering. Cannabis stocks also slumped on Friday as the initial excitement died down.

Despite high valuations for many Canadian cannabis companies, legalization opens the door to many investment opportunities in other companies in the cannabis supply chain. CIBC analysts predict that the Canadian weed industry will reach $6.5 billion in retail sales by 2020, greater than the amount of spirits sold in Canada. The published report also predicts that the private sector for cannabis should be able to generate EBITDA of $1 billion by the same year, with 85% coming from production and the remaining 15% from retail. Most of the EBITDA is expected to come from production because manufacturers process cannabis plants into a product with much greater value.

Defensive sectors gain as cyclicals fall

Defensive sectors posted the strongest gains this week. The S&P 500 Consumer Staples index led the gains for defensive sectors with a 4.27% increase, while the real estate and utilities components of the S&P 500 also posted strong increases of 3.22% and 3.05%, respectively. In contrast, consumer discretionary—a cyclical sector—posted the weakest performance this week, with the sector’s constituents on the index falling by 1.97%.

Defensive sectors provide stable earnings and have a constant demand regardless of business cycle, so they tend to perform better than the broader market during recessions. Cyclical stocks—a group that includes the industrial, financial, and materials sectors, have outperformed the market year-to-date. Cyclicals have also outperformed defensive sectors since November 2016, but the sell-off this week in cyclical stocks indicates a “risk off” rotation by investors into defensive sectors in response to the slowdown in the bull market.

The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the authors, which do not necessarily correspond to the opinions of University of Waterloo Finance Association (“UWFA”). Opinions expressed may change without notice. Opinions expressed may differ from views set out in other documents, including research, published by UWFA. The above information is provided for informational purposes only and without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of the information given or the assessments made.