When Bad News Is Good News For Australian Stocks

| About: iShares MSCI (EWA)

The relationship between currency weakness and equity strength is generally a function of ultra-low interest rates, which are geared toward enticing investors into stocks with the hope of increasing consumer demand. The FOMC's chairman Bernanke and the BOJ's Kuroda have certainly earned kudos amongst equity investors for their attempt at forcing investors out the risk spectrum, which calls into question whether other countries will follow suit given the current macro backdrop.

Tailwinds

Last week, the Reserve Bank of Australia reduced their benchmark interest rates by 25 basis points to 2.75% from 3%. The move was not widely expected as short term interest rate contracts had placed the chance of a cut at approximately 40% prior to the RBA decision. In the days to follow, investors punished the Australian Dollar (NYSEARCA:FXA) dropping it 3% to parity with the US Dollar (NYSEARCA:UUP), as expectations of future interest rate cuts were baked into the market. The Aussie is now down more than 5% from its peak.

Against the backdrop of the steadily appreciating Chinese Yuan (NYSEARCA:CYB) this rate cut could be seen as an even more aggressive move by the RBA to shore up flailing commodity exports. But, considering that the two countries just exercised a bilateral trade agreement replete with the diversification of reserves into each other's currencies it is likely that China is not overly concerned with a slightly cheaper Aussie at this point.

Following the meeting the central bank reduced its inflation outlook and reasserted that it forecasts the Australian economy would grow below trend in 2013. This type of statement shows there is an appetite by the RBA for additional interest rate cuts.

Investors might need to be patient with the RBA as the economy is likely to show mixed data throughout 2013. Last week Australia reported an employment change of 50,100 jobs, nearly five times more than analysts forecast. The unemployment rate slipped to 5.5%, and the currency popped generating a brief short squeeze. But, first and foremost the Aussie is a commodity-linked currency.

Headwinds

Historically, the Australian equity markets have benefited from strong commodity prices as it is a major exporter of coal, copper and iron. Unfortunately, the assets developed during the last credit creation cycle which ended with the busting of Lehman Bros. have reached their full productive capacity creating huge supply just as Asian demand has started to falter. This is the problem with aggressive central bank policy, the mispricing of risk in the form of low interest rates distorts the time value of investing and over-investment in long term projects like ore mine development is the result, driven by hot money flowing into infrastructure and construction projects.

China, Australia's largest trading partner, continues to release economic data that is softer than expected, which has put pressure on Australian thermal coal prices. Iron ore seems to have peaked and is back below $130/tonne. China's most recent Industrial Output growth of 9.3% fell short of the 9.5% expected by economists. PMI data released at the beginning of May was barely above the 50 boom/bust level. Chinese retail sales for April was in line with expectations printing at 12.8% year over year in April vs. 12.6% year over year in March. These numbers, however, have to be expected given the massive currency devaluations being carried out by China's biggest trading partners which now includes Australia to go along with Japan, the U.S. and the E.U., and the strengthening Yuan.

This is the effect of a real currency war and the reason why China is importing Gold (NYSEARCA:GLD) as fast as it can, buying very aggressively on every dip in the physical market.

The Equity Effect

In the end, the iShares MCSI Australia ETF (NYSEARCA:EWA) has notched a respectable 6.6% return in 2013 as of the middle of May, despite the soft economic backdrop investors are facing. As seen with the US and Japan, an aggressive central bank can make all the difference in lifting riskier assets regardless of the fundamentals. A declining interest rate environment and an aggressive RBA are likely to buoy Australian stocks in the short term despite the impact of negative sentiment due to declining commodity prices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.