The final trading days of September indicated how far Australian equity valuations could fall when the local currency dollar declines from its current heights.

In a warning that earnings forecasts for the Australian stocks were “characteristically too optimistic,” Hugh Giddy, senior portfolio manager and head of research at Investors Mutual, said it was worth remembering that offshore investors “will sell off in droves when, or if, the [local] currency retreats”.

Since the majority of international investors in Australia rarely bought beneath the largest 20 companies in the index, the effects of their withdrawal would be felt primarily in large-cap names, Giddy said.

But it was not only rapid depreciations in the Australian dollar’s value that could affect large-cap valuations, said Craig Connelly, managing director of Australian equities long/short boutique AR Capital.

He pointed to the increase in the Australian dollar’s strength during September, in which it rose from $US0.89 to almost $US0.97, prompting a sell-off in shares of the big four Australian banks and other large-caps at the end of September, in AR Capital’s view.

From September 29 to October 1, the closing price of shares in the Commonwealth Bank fell from $52.80 on September 29 to $50.90 on October 1, while NAB shares declined from $26.26 to $25 in the same period.

Observing this, Connelly and his team reasoned the movements were the outcome of the rising dollar, which buoyed offshore investors’ strategic weights to the Australian market and forced them to rebalance.

Other than making big, risky bets on currency swings, both Connelly and Giddy said there was not much investors could do to evade these devaluations.

“You can’t prepare for fund flows. You’ve got to have a process and a view,” Connelly said.

Giddy argued that broad earnings expectations from Australian companies were too positive given the economy’s reliance on the resources trade, weak bank lending to small businesses and an overall pullback in consumer spending.

“Our economy still lacks fundamental strength despite having low unemployment…Commodities can go very strong and then fall back,” he said.

Illustrating the new lending reality for small businesses, Frank Villante, CIO at small-caps manager Celeste Funds Management, said before the financial crisis banks would provide debt to companies at between 40-50 basis points above the bank bill rate – now companies had to repay at between 250-350 basis points above the bank bill rate.  

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