Why the Aussie Dollar Matters

International investors are thought to hold anywhere between 35% and 45% of the Australian market and the money is ‘mobile’, in other words it is held in the hands of fund managers, like Fidelity, whose offices are in New York, or London, and their benchmarks are global stock-market indices (mostly MSCI indices). Australia has been underperforming, a disappointment for international fund managers. If they were overweight Australia in the recent recovery they have underperformed.

For these international funds outperforming involves being overweight and underweight the right countries and their stock markets at the right time. Domestic fund managers, on the other hand, those who are benchmarked to the ASX 200 or similar, sit fairly fully invested in Australia at all times - their money is sticky, and is not mobile. Because that it is the international money, that doesn’t have to be invested in Australia at all, that is the swing factor on the Australian market.

International money is sensitive to the Australian Sovereign Risk (stability and predictability of Government policy – we rank very highly), the Australian economy (taking a turn for the worse at the moment) and the Australian currency (been performing very well in the recent recovery).

If the Australian economy detaches from the global economic herd, as looks likely thanks to this Australian second wave that is getting global headlines, the chances are there will be a few asset-allocation decisions made in New York skyscrapers, and one of the main ones will be “Sell the Australian dollar and Australian dollar denominated investments” which means “Sell Australian equities especially those geared to the Australian economy”.

You see international fund managers, although they might hold 35-45% of our market, don’t have to. Australia is a tiny part of most of their benchmarks, they can take us or leave us. For anyone benchmarked to the MSCI ACWI (All Country World Index - see below) Australia is just 2.06% of their index.

Most international fund managers work off the Morgan Stanley Capital Indices like the MSCI World Index and the MSCI ACWI index both of which include all the stocks in the MSCI Australia Index - not all Australian stocks are in this index, there are just 64 of them, Australian stocks, big stocks, which account for around 85% of the free float-adjusted market capitalisation of Australia.

MSCI Australia performance versus the World:

The MSCI ACWI (All Country World Index) is the MSCI’s “flagship” global equity index, designed to represent the performance of the “full opportunity set of large- and mid-cap stocks across 23 developed and 26 emerging markets” – it includes 3000 stocks, 11 sectors and 85% of most international markets. As you can see, within this index, Australia is just a little piece - almost irrelevant:

Country Weights in the MSI ACWI:

Sector weightings in the MSCI ACWI:

Top 10 stocks in the MSCI ACWI:

No Australian stocks here – you can see why Magellan has performed so well – the biggest stocks in its Benchmark are these MSCI World Index stocks, which are mostly high growth technology stocks, and compared to boring domestic Australian stocks, they have flown.

Australia is a small corner of the MSCI World. Here are the top 10 (predictable) stocks in the MSCI Australia index. These are the stocks the international fund managers sell and buy when they make a decision to enter or exit the Australian market.

And these are the sector weightings of the MSCI Australia index. As you can see 32% is in financials. Notably, information technology is just 1.74% of the index.

If the international investment community perceives a specific Australian economic risk they will also perceive a currency risk. When the stock market and the currency fall over together, international investors suffer a “double trouble”. They lose on the equity prices and they lose on the currency. The risk for us is if the Australian dollar starts to come off badly because of this second wave and the damaged Australian economic outlook. If it does the likelihood is that the equity market will follow it down.

But will the currency fall - who knows - in the eyes of the international investment community the Australian dollar is seen as a “commodity currency”, which means it is a cyclical currency tied not so much to the Australian economic trend as to the global economic trend, particularly the Chinese economic trend, which gets reflected in commodity prices. In other words the Australian dollar moves up and down depending on sentiment towards China and commodity prices and the global economic trend and those are set fair at the moment.

But you never know. What for a peak in the A$, it will change the market themes. It will favour our big international stocks (like CSL) and damage our domestic cyclicals (like banks).

The A$ peaked at 72.27c on Friday up from 55.06c on March 19. It is 71.21c this morning. Let see if it cracks or holds. If it cracks then there will be a few asset allocation meetings in New York skyscrapers that won’t favour the Australian equity market. If it cracks that’s another reason to keep your money in your pocket for the moment.

Finally – There are a lot of MSCI indices. There is even a World Ex-Australia and Fossil Fuels index. There are also ETF’s that cover most of the MSCI indices as well. Not necessarily listed in Australia though.