The Australian markets have had a great run in the past couple of months, but the wary trader should be looking to identify leading indications of any turnaround in investor sentiment. In this article we examine inter-market interaction for possible indicators of what lies ahead.
One such indicator is the Aussie dollar, which has finally reached parity against the US dollar. It’s strongly correlated to commodities prices and has been surging since May this year. The Aussie dollar’s strength and the corresponding US dollar’s weakness have driven commodities prices higher, underpinning the performance of our resource stocks. These in turn have been the driving force for our markets since the recovery began back in March 2009.
The surging commodities prices have driven domestic and overseas investments in our resource stocks, particularly in our second-tier miners which offer significant growth potential. However, with the exception of the consumer staples sector, all our other market sectors have been underperforming. This leaves the Australian market susceptible to a pullback if the mining sector falters.
Ahead of the G-20 meeting the US Treasury Secretary, Timothy Geithner, said the major currencies are “roughly in alignment now”, suggesting there is no need for further US dollar weakness. This may trigger a change in market fundamentals near term, with traders and commodities speculators enjoying a free ride on the back of the weakening US dollar.
A move away from the weak US dollar policy will mean that the Aussie dollar is set to pullback. Let’s take a look at what this means to commodities and our stock market performance.
The Big Picture
Over the past decade there has been a strong correlation between the strength of the Aussie dollar and the Aussie market as shown below: the Australian market is shown in red and the Aussie dollar in blue.
It is worth noting that the last time the Aussie dollar was around parity was back in mid-2008. At that time the markets fell sharply once there was a turnaround in the US dollar’s strength, which continued until the bottoming of the markets in March 2009.
In recent times there has been a divergence in the relationship between our market and the currency which has lasted a few months. Historically any divergence has been resolved within 4 to 6 months, either by the Aussie dollar weakening or the Aussie market strengthening.
Inter-Market Relationships Since the Global Financial Crisis
Since mid-2008 there have been two clear periods of divergence prior to now. The first was in late 2008 which was resolved in the ultimate market bottom of the GFC in March 2009. The second was in early 2010 where the ASX200 continued to rise but the Aussie dollar failed to make new highs. This resulted in the sell-off in April this year.
Over the past few months the Aussie dollar has surged, but the market has failed to participate in the bullish sentiment. As noted previously, historically any divergence has been resolved within 4 to 6 months, either by the Aussie dollar weakening or the Aussie Market strengthening.
The Commodity Currency
The performance of the Aussie dollar is closely tied to the price of commodities, as shown below. This relationship has held tight since the GFC. The CRB Commodities Index, illustrated below, comprises an index of a basket of commodities.
The Aussie dollar is referred to as a commodity currency, because our economy is so dependent on the export of commodities and is frequently bought up when investors look to add risk to their portfolio.
The Aussie market is being driven by the performance of our resource stocks which we highlighted in our recent Quarterly Market Performance Review. The other market sectors (with the exception of the Consumer Staples sector) are all underperforming.
We have shown in this article that market relationships and thereby investor sentiment may be due for a turnaround. The divergence in the performance between the Aussie dollar and the Aussie market will need to be resolved within the next 6-8 weeks, as there appears to be an imbalance between the bullishness over the Aussie dollar and the performance of the share market. The comments from the US Treasury Secretary suggesting there is no need for further US dollar weakness may be the trigger for a change in market fundamentals near term, as this will hurt commodities prices and in turn our miners and stock market going forward.
Look for leading indications that may result from a number of catalysts in the US markets in the next few weeks which could trigger a change in investor sentiment. These include: Corporate Earnings, the G-20 Meeting, the US Fed FOMC meeting, Quantitative Easing (QE2) and the US Federal mid-term elections.
Stay tuned for further analysis of prospects for the Aussie market. Next time we will examine the Australian market’s performance with relation to the US milestone events and Chinese influence.
By Michael Hevern
Head of Research