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ComSec Economics Analyst Craig James, Chief Economist Report Issued 21 September, 2000

A Litany of Risks: Oil, US Dollar Bubble, Aussie Dollar

Main Details: Australian dollar hits record low of US53.63 cents. Oil hits decade high of $US37.80/barrel. US stocks drop on inflation fears. US trade deficit at record in July.

Risks for Investors

If there was ever a time for investors to take a cautious stance it is now. Currency turmoil, high oil prices, thin local trading conditions and the upcoming G7 finance ministers meeting have created a situation of considerable risk. The vulnerability of the US equity market was highlighted last night with high oil prices and a record trade deficit sending the Dow Jones down 222 points at one stage. Investors must adopt caution in the current environment, monitoring portfolios and applying selectivity to investment.

To some extent there has been a degree of complacency about the increase in oil prices and likely effect on rates of economic growth and inflation. That complacency is gradually being wrung out. Analysts and investors alike are now asking questions such as, 'what if oil holds above US$40/barrel?' and 'what if the US dollar continues to appreciate?'. The other question is 'what are possible effects when the US dollar starts to weaken?'. Risks for Global Economy

Risks for the global economy seem to be mounting on a daily basis. Currencies continue to weaken against the US dollar and oil prices are setting fresh decade highs. Despite record trade and current account deficits in the US and uncertainty on future corporate earnings, the US dollar remains in the ascendancy. In real trade weighted terms, the US dollar is at 14 year highs. The overwhelming impression is that, sooner or later something has to give. The US dollar bubble is getting larger through investment flows but trade and current account imbalances suggest a weaker currency is required.

Finance ministers from the Group of Seven (G7) industrial nations meet in Prague this week-end. Amongst the items for discussion will be the strength of the US dollar and conversant weakness of euro and other major currencies, as well as the high level of oil prices. Given past inactivity by the G7, traders are not pinning high hopes on co-ordinated intervention. However intervention is clearly possible. As IMF chief economist, Michael Mussa, observed on intervention, "One has to ask, if not now, when?"

Intervention may only be effective if co-ordinated by major nations such as the United States, Japan and all the euro countries. However, there are doubts whether the political will exists. Japan has indicated support to correct currency imbalances but it is uncertain whether uniformity of support exists across all euro nations and the US. The situation is not a simple one. Judgements must be made about 'appropriate' currency levels and the risks of a weaker greenback on equity markets, inflation and economic growth in the US.

The strong US dollar has worked to offset inflationary impulses from high oil prices, tight labour markets and a strong domestic economy. If the US dollar weakens, some of the inflationary insulation is removed. This could lead to higher interest rates with predictable implications in terms of slower economic growth and weaker equity prices. A negative outlook for US equities may serve to weaken foreign interest, and potentially leading to the US dollar overshooting on the downside.

There is a degree of inevitability that oil prices will reach US$40 a barrel. A number of energy analysts are now raising the possibility of US$50 a barrel. An environment of sustained high oil prices particularly conveys risks of slower economic growth and increased inflation in developing and newly industrialising nations. Asia is seen especially vulnerable given that economic recoveries across the region are in relative infancy. Australian Dollar

The Australian dollar continues to take on water but no one is manning the buckets. The currency may only be slowly sinking day by day but there is a limit on how much water can be taken onboard. Overnight the Australian dollar fell to a record low of US53.63 cents but the currency had company with euro, New Zealand dollar, Swedish crown and South African rand amongst the currencies falling to record lows against the US dollar.

There appear only two possible life preservers that can be thrown to the Australian dollar. The first is a realisation that the Aussie is so undervalued on economic fundamentals that it represents a screaming 'buy'. However, there are few indications that the currency has bottomed. The other factor that could stop the Australian dollar falling further is agreement by the G7 to push the US dollar lower on global markets.

The Australian dollar has been trading below US60 cents for the longest period in history. The Aussie has fallen against the US dollar by 9.3% over the past month and is down over 21% since the start of 2000. The extent of the decline of the Australian dollar, together with decade high oil prices and firm domestic economy highlights the magnitude of the inflationary risk faced by the Reserve Bank.

There are all manner of excuses given for the sliding Australian dollar. The most credible are generalised US dollar strength and negative sentiment on Asia given high oil prices. Australia is grouped with Asia and the Australian dollar is the most liquid currency for investors to use to reduce Asian exposures.

It has been asserted that Australia is out of favour with investors as it is perceived an 'old economy'. In terms of technology, it is interesting to note that Sweden and Australia were recently ranked 1st and 3rd on technology indicators across 35 nations by Merrill Lynch but both the Swedish crown and Australian dollar have fallen to record lows against the US dollar. Craig James Chief Economist Comsec

http://www.stockhouse.com.au/brokerage/sep00/092100_comsec.asp

-- Martin Thompson (mthom1927@aol.com), September 21, 2000

Answers

A drop of 10% in just one month of a country's currency value is a route, one that cannot be sustaied.

-- Billiver (billiver@aol.com), September 21, 2000.