The COVID-19 pandemic is upending a lot of assumptions and giving forecasters fits as they try to assess what life is going to look like going forward. One area that is of interest to us as investors is the relative value of the Canadian dollar against the US dollar.
High on the list of things that are hard to predict is the value of currencies. Forecasters, traders and economists spill oceans of ink and spend hours of time trying to guess (really, it is a guess) if the yen, the pound or the euro will go up or down, and how much. It is tempting just to ignore the whole question, but in order to do our job, we can’t. Currently over 50% of all the equities we own for our clients are traded in US$. As we record our results in CDN$, the exchange rate has a real and quite significant impact on our clients’ returns. So we need to ask the question: Are we taking on extra risk by having so much exposure to the US$? Should we have even more? There are numerous factors that impact the value of currencies. Below, we have looked at what we believe are the most important ones and evaluated them as positive (that is, the value of the CDN$ will move up against the US$) or negative for the CDN$ against the US$.
Trade with the U.S. Currency is like other goods in that it reacts in the short run to supply and demand. Canadian exports drive currency demand as foreign buyers must spend CDN$, imports increase currency supply as Canadian importers must sell CDN$ to buy other currencies. Canada has lately been running a current account deficit, which puts pressure on our currency. At the moment, two of Canada’s top five exports to the US are under particular threat:
- Motor vehicles sales are in a deep recession at the moment. The GM plant in Oshawa is closed and the integrated North American supply chain has been shut down for the last two months. Only now is it restarting.
- The dramatic plunge in the value of oil and gas has been headline news. This has a devastating impact on Canadian exports. Large oil and gas inventories worldwide, our failure to move forward on pipeline projects, and the growth of renewable energy in the US (now larger than coal) suggest that Canadian exports will be constrained for a long time.
As a result we see trade as a significant negative for the CDN$ in the short run.
Interest Rates. The US Federal Reserve Bank and the Bank of Canada have been in a race to the bottom as interest rates have plunged towards the zero mark. Currently neither country has an advantage over the other with 10 year bonds offering less than 0.75 % per year in both countries. With rates so low, the flow of funds is much more motivated by perceptions of safety rather than relative yield.
We do not see interest rates as an important factor for either currency right now.
Strength of Economy. Prior to the pandemic, the Canadian economy had been doing quite well relative to the rest of the industrialized world. The combination of the crisis in the petroleum industry and the uncertainty caused by the health situation means that all bets are off for now. Nobody can predict what the economy in Canada or the US will look like in a few months, or how quickly GDP will return to pre-pandemic levels, but the technology-dominated US economy is likely to rebound more quickly and more robustly than Canada’s.
We see relative economic strength as a negative factor for the Canadian dollar.
Budget Deficit. Years of Canadian fiscal prudence have been swept away as the Federal government of Canada has thrown hundreds of billions of dollars at the pandemic in order to keep businesses, families and vulnerable individuals afloat. The Federal and Provincial budget deficits will reach heights not seen since World War II. There are no plausible plans to pay back the newly incurred debt in the short or medium term. It is true that the same thing is happening in the US, but with one very important difference. The US Dollar is the world reserve currency, against which all others are measured. Every country on earth holds US dollars to settle trade debt and as a storehouse of value to backstop its own currency. The US can sell unlimited amounts of debt at low interest rates, and is doing so. In contrast, the Canadian dollar is insignificant in world currency markets and constitutes about 2% of the total world currency basket. If investors turn against the Canadian dollar there is not much holding it up. We saw this happen in 2003 when our currency fell as low as 62 cents US, and we saw the “flight to safety” effect in the 2008-2009 recession when the Canadian dollar lost over 35% of its value in a six month period. The huge increase in our fiscal imbalance could cause a similar shift of funds out of Canada.
We view the Canadian budget deficit as a significant threat to the Canadian Dollar.
Purchase Power Parity (“PPP”). In theory PPP is the best way to tell if a currency is over or undervalued. Identical goods should cost about the same in different countries. If they are cheap here, that means the CDN$ is undervalued; if expensive, then it is overvalued. Statistics Canada calculates that one Canadian dollar has about the same purchasing power as 83 US cents. In other words, our currency is already trading at about a 15% discount to its value as a medium of exchange. While PPP is a good measure of economic well-being, and indicates that Canadians are actually better off than the raw numbers show, it has little predictive power about exchange rate movements, and significant over/under values can persist for long periods. However, at some point other currencies will flow towards the undervalued one in order to purchase assets such as companies, real estate and other real assets at a discount.
The current undervaluation of the Canadian dollar on a PPP basis is a positive factor.
On balance, we expect that the next year or two will be difficult for the Canadian economy and the Canadian dollar. We think that Canadians who invest in US stocks will likely have a currency wind at their backs due to the factors outlined above. However, the risk of wildcard or “black swan” events is unusually high right now. Health issues for world leaders, the progress in combatting COVID-19, the outcome of elections and other political events are even more influential and unpredictable than usual. That being said, we do expect that the percentage of our clients’ assets invested in non-Canadian securities will continue to increase.
