Interest rate differentials between the US and Australia are set to narrow further, creating Foreign Exchange opportunities for investors
2014 was another strong year for international shares, with only part of the gains for Australian investors attributed to a weaker AUD. However, with the prospect of Australian interest rates falling further, investors’ future income from currency hedging is unlikely to be as high.
2014 was another strong year for international shares which delivered a 15% return in Australian Dollar terms (assuming no currency hedging).
Although part of the return from international shares was driven by the decline in the Australian Dollar (which fell 8.5% against the US Dollar in 2014), overall currency gains were less than this. This was because the Australian Dollar rose about 4% against the Yen and Euro, reducing gains from currency to about 4-5%.
Given further falls in the Australian Dollar so far this year to US$0.77 – 78 (and economist estimations of fair value at US$0.75), our expectation of further currency depreciation is much lower than previously.
However, whether we shift our recommendation to fully or partially hedge international equities exposure remains an open question. In the past, there were significant income benefits from hedging against changes in the exchange rate. This is because short-term interest rates in Australia were much higher than other major markets. Going forward, the outlook is for a second cut in Australian official interest rates while US interest rates “normalise” back up to pre-financial crisis levels. This means income from currency hedging is unlikely to be as great. The other fact to consider is the portfolio diversification benefits an investor receives by remaining unhedged. Our currency tends to fall at times when investors are reducing risk (that is, selling shares or commodities) so currency can act as a good investment “shock absorber”.
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