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Battling Aussie battles on

WHEN you start an article as follows “If there is one thing the markets have taught us it is that investment fundamentals can’t always explain price movements” you know that you are going to get the attention of most analysts.

So it was I came to read Robert Prugue’s piece on the VanEyk website entitled “Little Aussie Battler”.

As Robert sees it: “Last year was the year of the NASDAQ bubble; only to see all those unrepeatable gains wiped out as quickly as they came in. This year might be the year of irrational pessimism.”

Any asset that is vulnerable to the pending recession will see its price fall precipitously. Against the mighty US economy, our Australian dollar is one such asset.

The fact the Australian dollar is trading under 50¢ against the US appears to have not just perplexed Mr Prugue. He was perplexed when the cross rates were at 55 US¢. Now at the current levels he is downright dumbfounded. At the current rates he is drawn to issuing a challenge to anyone to justify this level.

When we went through our university careers, we were always told that three differentials influenced exchange rates: inflation, real interest rates and the current account deficit.

The inflation differential typically sees the country with the higher “expected” sustained inflation to see its currency weaken over the longer term.

As Mr Prugue argues, our secular/long-term inflation is lower within Australia than it is in the US.

On the interest differential, it is typically the country with the lower interest rates that will see its currency weaken as investors chase higher returns from outside.

Australian cash rates are higher than those in the US. Shouldn’t our currency therefore be higher?

The current account differential is the last factor that determines the exchange rate. In this area we do have a high current account deficit. But ours is improving, unlike that of the US.

So on the three fundamentals that are seen to determine the exchange rate, we seem to be in a better position than the US. So why does our currency languish at the expense of the US?

Mr Prugue argues, as he has for some time, that the misvaluation does not lie with our undervalued Australian dollar but perhaps on the overvalued US dollar.

The analysis VanEyk has done suggests that the Australian dollar has a fundamental valuation currently between 58 to 62 cents against the US dollar.

So at the very least, Mr Prugue would anticipate an appreciation of anywhere between 15 to 20 percent against the US.

With every economic analysis there is usually a downside.

Mr Prugue warns “But before we pop the champagne, a rising Australian dollar is not good news for those international investors. Want to confuse your neighbour? Tell them how a strengthening AUD is bad for the average international share fund.

“As we argued, the stellar results from international shares were not delivered by stellar returns on international shares but from rapid rises in the USD. Any fall in the USD would detract from international share returns, given that the US share market represents over 50 per cent of the world’s share market capitalisation.”

So, at least we can look forward to a stronger Australian dollar by the end of the year.

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