Elections. Sports events. Stock prices. There are a lot of things in the world that are hard to predict. Among them, and high on the list, 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 about 40% 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: Do we have too much currency risk in our portfolios? 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 or negative for the CDN$ against the US$.
- Trade with the U.S. Currency is like other goods in that it reacts in the short run to supply and demand. Exports drive currency demand as foreign buyers must spend CDN$, imports increase currency supply. Canada has lately been running a current account deficit, which would tend to put pressure on the currency. At the moment, three of Canada’s top five exports to the U.S. are under threat:
- Motor vehicles are 16.5% of total exports. With NAFTA now being renegotiated, this sector could face new trade barriers; as well, auto sales may have peaked.
- Energy exports are 16% of exports. The low prices for oil, gas and coal reduce the value of our exports, but more important is the growing energy independence of the U.S., due to new oil and gas drilling technology
- Lumber products are 3.4% of exports. The seemingly perpetual battles over Canada’s softwood lumber exports have heated up again, with the U.S. levying punitive tariffs.
As a result we see trade as a significant negative for the CDN$ in the short run.
- Interest Rates. Hot money goes where it gets paid the most. The U.S. Federal Reserve Bank raised interest rates for the third time in a year in June. The Bank of Canada has so far not moved at all. U.S. rates are significantly higher than Canadian ones all across the yield curve, and significantly so in the 3 to 10 year range. This encourages cash to leave Canada and go the U.S., putting further supply/demand pressure on the CDN$ and depressing its price. Interest rates may rise in Canada sooner than we think, based on recent statements by the Governor of the Bank of Canada, and this has been reflected in a very fast upward move of about 5% in the CDN$ in the past two months; but at the moment interest rates remain a net negative for the CDN$.
- Strength of Economy. The Canadian economy seems to be doing surprisingly well and may have the best growth in the entire G7 this year. Employment levels are rising in Ontario and elsewhere and GDP is gaining in the 3% range. There may be a “broken window” effect from the Ft. McMurray re-build that is slanting the numbers*, but in any event, Canada is growing faster than the U.S., has better demographics as a result of our higher level of immigration, and likely has more economic slack to take in, fostering growth. We see economic strength as a net positive for the CDN$.
- Budget Deficit. Canada will run a deficit this year on the Federal level of 2% of GDP. Most provinces seem to be getting their deficits under control but will likely add another 1% of GDP for a total senior government deficit of about 3% of GDP. This is very comparable to the U.S. Federal deficit, calculated by the Federal Reserve Bank at 3.2% of GDP. On this measure, there is little to choose between the two currencies.
- Purchase Power Parity (“PPP”). PPP is the best way to tell if a currency is over or under valued, in theory. 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. The Organization for Economic Cooperation and Development calculates that on a PPP basis the CDN$ is worth about US$0.81 or about 7% more than the current exchange rate (http://stats.oecd.org/Index.aspx?DataSetCode=CPL). While PPP is a good measure of economic well-being, and indicates that Canadians are actually better off than the raw numbers show, it has little predictive power in the short run on exchange rate movements, and significant over/under values can persist for long periods. Nonetheless, we would rate this as a positive for the CDN$.
- Commodity Prices. The world, rightly or wrongly (mostly wrongly) views Canada as a commodity based economy. In 2011, only six years ago, the CDN$ rose to US$1.06 on the back of a huge commodity boom during which oil rose to over $100/bbl, and subsequently sank to under US$.68 due to very weak commodity prices about a year ago. Key energy commodities (oil, natural gas, coal) appear to be in long term decline, not just cyclical decline, due to changes in energy production and consumption. Key metals such as iron, copper, zinc and lead have recovered somewhat but are not showing evidence of strong upward movement. We find it hard to see commodity prices boosting the CDN$ any time soon, so this factor is a negative.
- Wild Card Events. The U.S. is led by an inexperienced and unpredictable administration. Literally anything could happen, from the nuking of North Korea to the impeachment of the President. Wild cards are impossible to predict by their very nature. However, the impact of events like 9/11 has, perhaps ironically, usually been to drive the US$ higher as world investors seek a safe haven in the international reserve currency. We doubt that the CDN$ will move radically due to a random U.S. event, but it is worth remembering that the CDN$ lost 25% of its value against the US$ in the six month period between September 2008 and March, 2009, during the world financial crisis. Wild card events tend to be negative for the CDN$.
Canada accounts for about 2% of world GDP. Our currency is not a reserve currency and would not appear at a significant level in most central banks’ foreign reserves. We care about it because it is what we earn and what we spend; the rest of the world is largely indifferent. In contrast, the U.S. accounts for about 22% of world GDP and the US$ is the international reserve currency. In spite of occasional rumblings, it is what all central banks need to hold. While the situation in Europe has improved, it is still fraught with concern about its weak southern tier (Greece, Italy, Portugal, and Spain). China has huge debt and transparency issues. Japan has no growth and is a demographic black hole. The pound sterling does not bear mentioning due to problems arising from Brexit and a very weak government.
Our conclusion is that the US$ will likely at least hold its own against the CDN$. While the situation bears watching (and we will continue to monitor it closely), on consideration and analysis, we are not overly worried at this time about the currency risk arising from our clients’ holdings of U.S. stocks.
*Gross domestic product measures economic activity, whether or not it is productive. As economists have pointed out, one way to boost economic growth would be to pay one set of people to break windows, and another set to replace them. The disastrous fire in Ft. McMurray last year is a huge, natural, broken window event.
David Baskin
July 7, 2017
