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What to do if the Australian dollar stops falling

Various media outlets have speculated that if the Australian dollar rallies from its current two-and-a-half-year lows to back above US$1, the negative effect on the economy will slow growth and the Reserve Bank will be forced into further rate cuts.

The rate cuts will be used to stimulate the economy — primarily the slowly improving housing market — in an attempt to make Australia less appealing to overseas investors, thereby putting downward pressure on the Australian dollar. The theory being that higher interest rates indicate a stronger economy and provide better returns on government bonds compared to the US.

Much has been written about the positives of the falling dollar, which could result in a decrease in consumer sentiment, affecting consumer spending and hitting retail and companies linked to economic growth in the back pocket. The rising exchange rate would also reduce the earnings of US-exposed companies and net importers, diminishing much of the upside potential in the forthcoming earnings period.

BUT, and it’s a big but, these arguments dismiss the underlying reason why the dollar rises. The reason why the dollar has been held over US$1 for most of the recent past is due to the relevant strength in the Australian economy compared to most other developed nations. Coupled with high(er) interest rates, government bond yields, and the 5%-7% dividends on offer in the ASX, the Australian dollar has seen strong support from overseas investors.

Overseas investors purchasing Australian bonds and shares in Australian dollars have helped to keep the dollar high in recent times. Conversely, the recent drop in the dollar and ASX has been primarily due to international investors withdrawing their funds as the US economy strengthens and fears about the future of the Australian economy intensifies.

If the Australian dollar rises, it will again be due to strong support from overseas investors. It will most likely be due to evidence of weakness in the US economy or positive signs from China, which will directly benefit the Australian economy. China is still growing at over 7% a year on an economy twice as large as it was 10 years ago. This simply cannot be bad news for Australia. Housing is gradually improving, consumer sentiment is stable and unemployment is holding steady. These are all good signs for Australia, perhaps the future isn’t quite so dire.

The 12% depreciation of the Australian dollar versus the US dollar in recent weeks means that for overseas investors with US dollars, Australian shares are 12% cheaper. Telstra (ASX: TLS) shares are down 11% in three weeks and are yielding over 6%, which makes for a very strong buying opportunity. It’s a similar story for bank and financial companies: Westpac (ASX: WBC) is over 15% cheaper and yielding 5.8%, ANZ (ASX: ANZ) is 13% cheaper and yielding 5.5%, National Australia Bank (ASX: NAB) is 14% cheaper and yielding 6.23%, and AMP (ASX: AMP) is 10% cheaper and yielding 4.93%.

Foolish takeaway

Some overseas investors have been burnt by the recent falls of the ASX and the Australian dollar. Australian shares are now over 20% cheaper in US dollar terms than they were a matter of weeks ago. My bet is that the demand for defensive and bank shares is not over and a healthy exposure to the high-yielding sectors has a reasonable chance of outperforming over the short to medium term.

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Motley Fool contributor Andrew Mudie does not own shares of any companies mentioned in this article.

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