BofA with an interesting take. All fair enough, I reckon. Except on one score. As the Fed breaks the US economy, and an epic inventory destocking event begins, China will get absolutely creamed in 2023.
Weak AUD has been resilient, all things considered
AUD/USD is at fresh lows vs. USD with the low 0.60s commensurate to global “crisis” levels of October 2008 and March 2020. However, the bilateral exchange rate misrepresents what has been remarkable resilience in trade weighted terms to massive China import compression and global recession concerns (Chart of the Day). The positive terms of trade shock partly explains this but so do structural shifts in Australia’s BoP that may be more durable over time. As a consequence, while AUD/USD remains vulnerable to a global slowdown, AUD crosses should hold up better – AUD/NZD fair value for instance has risen above 1.15.
AUD weakness is deceptive
As global recession concerns rise, commodity currencies have unsurprisingly faced the brunt of this pessimism. AUD is no exception reaching new lows vs. USD with the low 0.60s commensurate to “crisis” levels of October 2008 and March 2020. However, due to broad USD strength, the bilateral exchange rate misrepresents what has actually been notable resilience in AUD, all things considered. Consider the following:
• Despite its recent drop, AUD is still the third-best performing G10 currency (ex USD) year-to-date after CAD and CHF.
• As a consequence, the RBA’s trade-weighted AUD index has remained in a broad range (60-65) since June 2020. Looking at the TWI ex USD, the AUD is in fact 2% stronger year-to-date and well above historical crisis levels {Exhibit 1).
• AUD/JPY, the classic global growth proxy, remains close to historical highs despite the recent pullback. Much of this has to do with JPY depreciation due to policy divergence but reflects AUD resilience too.
• China’s imports from Australia have collapsed as a consequence of the property market slowdown. In past episodes of a negative China import impulse – specifically 2015-16 and 2020 – the AUD TWI weakened by at least 5% YoY. In contrast, the AUD has been resilient to the latest collapse (Exhibit 2).
AUD has outperformed its PCA implied move (so has NOK)…
We update our principal component analysis (PCA) approach to quantify the outperformance of AUD. We apply PCA to G10 pairs (vs. USD), extracting three components that explain the bulk (94%) of the co-movement between the exchange rates. To the extent these are “drivers” affecting all currencies, we assume they capture external factors. Looking at simple correlations of these components with market prices allows us to infer the underlying fundamental drivers, which we have previously identified as the US dollar, risk and rates.
Exhibit 3 compares the actual vs. estimated performances of G10 pairs from 30 May until 7 October 2022, using weekly data. The estimated performance is out-of-sample, based on individual betas of each G10 pair vs. USD to the three PCA components since 2010. While NOK and AUD have weakened, the depreciation has been far less than their historical betas would imply. This is likely related to the positive terms of trade shock for these countries, which is not directly captured by the PCA factors. Our constructive view on energy prices for instance is partly why we are constructive NOK despite this
statistical discrepancy.
… but this may be due to structural & durable BoP shifts
The surprising resilience of AUD begs the question of whether it reflects temporary or durable factors. The terms of trade shock discussed above is arguably most at risk if China remains weak and/or global energy prices fall – indeed Australia’s terms of trade has deteriorated over the past month. However, we expect the China impulse to be more supportive moving into 2023 (Exhibit 4). Moreover, there are potentially durable structural changes in Australia’s balance of payments (BoP) that suggest AUD’s trade weighted resilience could persist.
• China matters but our economists have highlighted the diversified nature of Australia’s boom in goods trade (The diversified trade boom 16 August 2022). Energy export earnings (primarily coal and LNG) now exceed iron ore, while exports to other major Asian economies now exceed China (Exhibit 5). This is the main reason the collapse in China’s imports from Australia has weighed less on AUD relative to previous episodes.
• Trade diversification extends beyond goods exports. The pandemic disrupted a trend increase in Australia’s service exports, with its share in total exports falling from over 20% to less than 10% in June 2022 (Exhibit 6). But this has started to recover as borders reopen – while the recovery will be gradual and partly driven by the reopening of China to outward bound travel, it will provide further diversification from the global manufacturing cycle over time.
• Australia’s international investment position is key: at -34.2% of GDP in 2Q22, the NIIP is at levels last observed in the 1980s. This improvement is the consequence of running large current account surpluses in recent years. But the composition of this increase is critical – the recycling of current account surpluses to foreign equities (primarily by superannuation funds) has taken the net foreign asset position in equities to +14.8% of GDP, having more than doubled in the past three years. Australia’s net creditor position in equities may also explain its trade-weighted resilience to the global equity sell-off.
