Rational Advisor

The Canadian dollar has seen some steep ebbs and flows in its history. In 1864, the greenback traded at $2.78, an all-time low for the U.S. currency. In 2002, by contrast, the loonie traded as low as 62 cents.

What’s happened to the Canada dollar is a once in a decade event. Much of the impact of foreign investments has been muted to the extraordinary increases in the Canadian dollar.

The Canadian dollar has not only appreciated against the US dollar, but also against all other major currencies

Appreciation to Sept 24, 2007
Against US Dollar 16%
Against the British Pound 14%
Against the Japanese Yen 13%
Against the Euro 10%

What does this impact, it impacts the returns negatively of all investments based in these countries that are made in Canada.

&P/TSX Return 8%

S&P 500 Return in US dollars 7%
Same S&P 500 Return in Canadian dollar terms -8%

EAFE Return in local currency 3%
EAFE Returns in Canadian dollar terms -7%

This influence impacts all portfolios that are globally focused. Negatively.

The issue is not answerable by hedging against one currency, the US dollar, but for hedging against all these major currencies – this is an expensive proposition.

Portfolios that have a higher weighting in Canadian content however did not feel this impact, and did better over the past few years. This is ironic since just a few years ago; the government chose to remove the RRSP limits on global content in portfolios.

Is this Canadian dollar sustainable, can it appreciate at the same time, and can Canada remain as a leading economy around the world?

Why has the Canadian dollar appreciated and when did it appreciate

The rise in the CAD is a result of a number of factors, prime among them, the relative weakness of the US dollar as of a result of spiraling debt, both public and private. Secondarily, our resources; oil, gold, base metals,, even wheat are at near record highs with demand soaring in Asia. Thirdly our own debt position is good, and improving. Fourth, the massive amounts of buyouts almost $1 Trillion of Canadian companies. All in all a perfect storm of confidence in the Loonie.

But, it’s the drive for commodities which is the greatest impact on our currency. See, we supply Oil to the world, and they have to buy it in Canadian dollars. As the price of Oil goes up, the need for Canadian dollars goes up.

Much of the appreciation of the Canadian dollar can be attributed back to Sept 2002 to March 2003. The chart below is against the US dollar, but reflects similar changes against the other currencies.

What happened in that period was uncertainty in directions for Global commodity usage. The US announced plans to save an Oil rich country, Iraq from a tyrant. The announced their concerns around Weapons of Mass Destruction in September 2002, and entered Iraq in March 2003. Since then they have had an increasing presence there. The Canadian dollar appreciated from 62 cents to where it is now.

This turmoil caused concerns around global Oil shortage, and an increase in currencies for all countries that are commodity based. The five major countries whose currencies have appreciated the most in that period — Norway, Brazil, Australia, Canada and New Zealand — are each prolific producers of natural resources. As commodity prices rise, so does the value of their exports, and their currencies. The U.S., as a huge importer of oil and other raw materials, pays the price. Those are macroeconomic forces.

As the scenario for trouble in Iraq progressed, more and more US debt was taken to support the US troops there. This increased the US debt.

Then In the midst of the credit crunch, investors become leery of risky U.S. and European credits, and this has created a recent rush into emerging and commodity markets that are, ironically, perceived as less risky. This rush has actually been a phenomenon of the last few years, an exit from the U.S. into the emerging and commodity markets, because they are apparently safer investments!

The drop in US rates to reduce concerns around credit paper also led to a fall in the US dollar against the Canadian dollar, allowing it to hit parity. And don’t we know it, almost every paper had that as their main headline news. Right now, we may be seeing speculators pushing the loonie to par and beyond, rather than underlying economic forces. Parity is just a number! This entire obsession with parity is unfounded. The exchange rate for the dollar is not a good indicator of how strong the economy is. The important measures of economic strength are employment growth, GDP and inflation.

We are no way as rich as the Americans, the European, or the Japanese by every economic yardstick, from standard of living to personal income. For sure we can go into a US store and buy goods with the same power as an American, but the fact is their counterpart in the states still earns about 20% more than the Canadian does.

Is it sustainable?

From RBC , they documented that currently the Purchasing Power Parity is at an extreme, and has hit its 20% overvaluation targets. When they do reach this extreme, they don’t stay there for long.

What could upset the apple cart?

We have to first recognize that the key reason for the Canadian currency appreciation is tied to the price of Oil, and the acquisition of Canadian companies from foreign entities. The price of Oil is in turn dependent on global supply and global concerns around Iraq and Iran. The appreciating Canadian dollar also makes it more expensive to do purchase in Canada, so the Merger and Acquisition activity could be lower for Canadian companies. The Federal Government is reviewing changes on legislation regarding acquisitions by foreign entities.

For the supply side of Oil

Firstly, the US elections are next year and almost every candidate has discussed the reduction of troops in Iraq. This will have a psychological impact on that region, and some influence on concerns around

From a recent article in Barron’s:

Over the past year, Saudi Arabia has had to cut its production by almost a million barrels a day to accommodate the impact of non-OPEC supply growth and because of weaker-than-expected world oil-demand growth. It wasn’t that they were depriving people of barrels, but OPEC had less demand for their oil — and the bulk of the cuts occurred in Saudi Arabian production. The Saudis are about to bring on a big field in the fourth quarter, Khursaniyah, that’s an 800,000-barrel-a-day project, and they are looking at demand numbers that are being revised downward. World oil-demand growth hasn’t been at nearly the pace people thought it would be.

Qualitatively, you should know nobody is being deprived of barrels. Now, with the Saudis pushing for a higher quota, it is not about making barrels available to meet demand. It’s about sending a signal or trying to lever down oil prices. The reason they want to do that is because the higher average price levels we’ve seen for the last couple of years have affected demand growth, and they have affected supplies from non-OPEC countries and for alternative energy supplies. The Saudis are the ones bearing the brunt of that because as demand for their oil has dropped, they have been the ones that have had to cut back.

What about the demand from China and India and the notion that supplies have peaked? The data doesn’t show it. If you look at the International Energy Agency industry data and you do an apples-to-apples comparison of non-OPEC supplies, supplies from all of the countries outside of OPEC, you will see growth rates are running substantially higher than people believe to be the case. Growth in non-OPEC supply this year looks like it will be about 1.3 million barrels a day, and that number is about twice what people believed would be the case. And the Saudis clearly have the barrels available. They are bringing on new fields. Khursaniyah is coming on in the fourth quarter, Nuayyim next year and Shaybah next year and Khurais in 2009. These are fairly big additions.

We have never seen the gap between reality and the perception of reality as big as it is right now. The perception of what is called Chindia, the idea that demand growth globally is robust and is going to be led by the emerging-market economies of China and India, is still strong. It is a great idea. But when you look at the data, you will see it doesn’t match, and when you talk about peak oil and see what is happening to non-OPEC supply, there is a problem because supply growth this year is going to be one of the largest in almost 30 years, and next year looks like it is going to be similar to this year. Biofuel supplies, which include soybeans for diesel fuel and corn for ethanol, will be up this year roughly 350,000 a day versus last year. That’s a big number, about 40% in terms of its volume. It is going to be up by a similar volume in 2008. This is in response to higher average oil prices and concerns about availability.

It is expected that with the increased amounts of supply, the falling in demand, and the change in political governance of the US, that Oil prices may have more downside than upside.

Since most commodities are priced in U.S. dollars, a recovery in the US Dollar would also give commodities markets serious setbacks and by extension cause emerging markets to fall back, too. This is the nest biggest concern, and the one that most are not concentrating on

Why would a US dollar appreciate?

In the currency market, everything is cyclical. A strong currency will eventually become a weaker one as it hampers growth while a weaker one will eventually become a stronger one as it spurs growth.

What this means is that unless the U.S. goes out of business, the dollar will eventually turn around. The ensuing chain of inter-market events should cause commodities and emerging markets to pull back.

A bubble is currently forming in Emerging and commodities markets, all because of a dropping US interest rate and thereby its currency. I find it hard to bet against the US, after all they control almost half of the world’s wealth. The US didn’t become the world’s wealthiest nation by accident. It will rebound, it always does. The mortgage crisis, and the resulting economic slowdown, will shrink the trade deficit. And Mr. Bush is now a lame-duck president whose party might well lose in 2008. Anyone remember how the U.S. economy — and the currency — performed during the last four years of Clintonomics? Think of all of the world class companies that they have – Wal-mart, Proctor & Gamble, General Mills, etc.

I think what we are seeing now in the US dollar is similar to what happened with Canada in the 1990s. We had way too much debt. And deficits were WAAYYY too large. We were basically forced into devaluation scenario to pull out of this nosedive. The US is attempting the very same thing now. Just as Canada got out of its debt problems, by dropping its currency and increasing its trade, so will the US. I don’t know how long it will take, but it will work out for the states.

A Lower debt US, with higher export trade, less foreign involvement could make for an attractive currency.

Could the Canadian dollar go to higher against the US dollar? Absolutely, Currencies in the short term are driven by momentum and sentiment and right now the momentum is creating that tailwind for the Canadian dollar.

There is plenty of uncertainty for the market to deal with in the months ahead, including a huge wave of mortgage resets in the U.S. at the first of the year, where homeowners holding adjustable rate mortgages will be paying sharply higher rates.

On top of that, there are still big problems with liquidity in financial markets and central banks continue to inject billions of dollars to keep those markets running smoothly.

The downside isn’t just confined to U.S. markets, now that the Canadian dollar has brushed past the parity level with the greenback after jumping about six per cent during September.

For Canada there is a good chance that we could see Canadian interest rates come down – Our dollar is too high, and inflation is low. The Canadian dollar may have overshot its fair value is trading at a level above what the country’s economic fundamentals justify. There is probably about 5 cents of headlines movement that is speculative.

Bank of Canada Governor David Dodge has said that speculative gains in the currency would cause monetary policy to be more stimulative than it otherwise would have been” — in other words, lower interest rates.

What’s an investor to do?

Investors can expect more big swings in the stock markets in the coming weeks as traders react to each and every nugget of economic news.

Try to remain rational. Global focused portfolios may not look attractive right now, and that is something that is seen in every bubble environment. Rational investments get trumped by irrational momentum based investments. In the Technology era, which also lasted five years, investors who did not hold technology were penalized, yet when the eventual realization of reality came, it was those investments that had lower technology weightings made the most sense.

Having a globally focused portfolio although it currently seems the hardest thing to do, actually is the most prudent. In fact, your own emotions maybe the greatest investment tools – the investment you want to move out off, maybe the best one to be adding to it. Rather than reduce your exposure to Global portfolios now maybe a better time to add to them with a higher Canadian dollar.

Diversifying, across borders, sectors and company size, is a brilliant strategy. However, forget trying to predict which geographical area, size or type of company is going to be on top in a given year.
In fact, of 10 major global market indices, every single one has put in at least one great year of performance between 1985 and 2005 and every single one has suffered a bottom finish as well.
The lesson is quite simple. Spreading your investments more broadly will increase your performance over time but, more importantly, the strategy will reduce risk. You just need to have the patience and willingness to stick to your discipline.

Look at 20 years ago. The market was at all time highs, then came a surprise rate cut, a weakening US dollar, all followed by a crash. It’s scary to imagine that it could happen again and we could see a fall of 20 per cent or more in the major indices. Having a diversified approach, not concentrating on the hottest themes, would have protected you in such an environment.

Rational

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