Three Ways to Profit From Australia's Strong Dollar and Massive Natural Resource Reserves

By Martin Hutchinson
Director of Global Investing Research

Australia has had an excellent run in the last decade, benefiting from sound economic policies and rising natural resource prices. While the economic policies may be about to change, Australia's innate natural resource strength will only increase as demand from East Asia grows. That means that only some Australian investment strategies will work. Which ones, we'll soon see.

Australia is not like Canada, which we chronicled two weeks ago. Both of Canada's political parties are committed to the free markets, its unions are relatively weak and the left generally focuses on cultural rather than economic issues. In Australia, however, unions are strong and the Australian Labor party is from time to time genuinely anti-capitalist. Conservative Prime Minister John Howard, in office since 1996, has done a great job, but he is facing election, probably next month, and he may well lose. The Labor opposition, under Kevin Rudd, plans to appoint a number of union leaders to the cabinet, and is threatening to raise taxes and reverse many of the reforms that have produced Australia's economic dynamism.

Australia's manufacturing economy - like Canada's - is not overly impressive. Australia's manufacturing sector suffers from its distance from major markets, from union problems and from the competitiveness of Asian manufacturers in present the Australian market.

Agriculture, traditionally an Australian strength, now represents only 3.8% of Australia's $645 billion Gross Domestic Product (GDP), although meat and wool are still the country's No. 2 and No. 3 exports. The real estate and construction sectors have been strong for the last few years, but Australia is now suffering through the same housing-bubble hangover as other key markets around the world (such as the United States).

Australia's Natural Resource Muscle

The Australian dollar recently touched 90 cents against the U.S. dollar, a level not seen in 23 years. It has been lifted not by a favorable payments balance (Australia currently runs a payments deficit equal to 6% of GDP), but by two other factors: speculation and natural resources.

The speculative effect is quite clear. Since Australia has somewhat higher interest rates than the United States, the Australian dollar has been a favorite target for the hedge funds' "carry trade" strategy, under which they borrow yen at short-term rates below 1%, and lend in higher-yielding currencies - pocketing the interest-rate spread as the profit. That speculative trade has been a highly profitable maneuver for more than two years. But it cannot last forever. At some point the Bank of Japan will raise interest rates (BOJ policymakers voted once again last week to keep rates steady) to make this trade less attractive, the yen will rise and the Aussie dollar will fall as carry-trade positions are unwound -and quite rapidly, too.

Australia's natural-resource wealth is globally well known. Most of its natural-resource muscle is in minerals and agriculture; it is a net importer of oil, although it does export a little natural gas. In energy, Australia has 23% of the world's uranium reserves - more than Canada - and it has a natural market for its output in China, which is moving more strongly into nuclear energy as the pollution and global warming problems of its existing coal-fired power stations escalate.

Australia's No. 1 export, worth $21 billion in 2006, is coal, mostly shipped to the rapidly growing economies of East Asia. Coal production and exports have climbed steeply. The principal bottleneck is the port of Newcastle, New South Wales. In May, New South Wales became a global case study of the world's overheated coal market, reporting record turnaround delays of over a month: At one point, no fewer than 79 ships were awaiting servicing.

Needless to say, port expansion is a top priority. But that takes time.

Mining remains an extremely important Australian industry. Its major exports are gold, alumina and iron ore - the prices for all of which have more than doubled in the past few years on the back of exuberant Asian demand.

Where to Profit?

Australian industrials are not very interesting, particularly with the threat of a Labor government and stronger unions, as well as the reality of a strong Australian dollar - all factors pushing up relative production costs. As with the U.S. market, construction and finance should currently be avoided. Agriculture and agricultural commodities could be attractive, but none of the major Australian agribusiness companies have ADRs, so it's difficult for U.S. investors to participate.

That leaves mining and energy. There are no pure Australian uranium plays, but Rio Tinto PLC (RTP) has a very large Australian operation, active in both uranium and metals, and also has a very large uranium operation in Namibia and major aluminum production through its planned $40 billion purchase of Canada's Alcan Inc., (AL).

That deal is to close in the fourth quarter.

In coal, the largest producer is BHP Billiton Limited (BHP), which also has huge operations in iron ore and South African gold. This makes it a well-diversified exposure to the mining sector.

Another well-diversified, purely Australian mining company is Alumina Ltd. (AWC), which is active in nickel, copper, uranium, gold and fertilizers. It also has a joint venture with U.S.-based Alcoa Inc., (AA), that ranks as Australia's largest bauxite miner and aluminum smelter.

Rio Tinto, BHP and Alumina are all trading at Price/Earnings ratios in the mid-teens, based on their recent bull-market earnings, making the shares rich, but tolerable.

Since energy and mineral prices are currently rising even faster than the Australian dollar, Australian minerals and energy companies should be well hedged against a further rise in the currency, which brings increasing costs to Australian production. Given the political and currency risks, it's probably best to concentrate Australian investments in these sectors.

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