The rise in the value of the Canadian dollar this year has undermined the performance of portfolios that have meaningful exposure to foreign securities. The Odlum Brown Model Portfolio1 is a case in point, as more than half of our investments are outside the country. The Model was up as much as 6.9% as of mid-May largely due to the strong performance of the U.S. stocks in the portfolio, but we have given back almost two-thirds of that gain as the loonie has taken flight.
The major U.S. equity benchmarks are still up more than our S&P/TSX Total Return Index this year, both in local currency and when converted to Canadian dollars. Nonetheless, some clients are understandably apprehensive about the possibility of the Canadian dollar rising further. It’s a fair concern and one that we ponder often.
Currency is one of the many factors we consider when we assess the appeal of foreign stocks. The economic cycle, the outlook for various sectors, company-specific fundamentals and relative valuations are other major variables that influence our enthusiasm toward foreign investments. Based on our analysis of each factor, we are still keen to invest outside the country.
A good starting point to assess currency risk is to compare the current exchange rate to its purchasing power parity value. Purchasing power parity, or PPP, is the theoretical exchange rate that would make an identical basket of tradable goods equally priced in two countries.
According to the Organisation for Economic Co-operation and Development (OECD), the PPP value of the Canadian dollar was US$0.79 at the end of 2016. With that approximation of “fair” value roughly in line with the current exchange rate, it’s hard to argue that investors should be overly concerned about currency risk. Other factors are probably more important at this juncture.
Still, while PPP tends to be a good long-term anchor for exchange rates, the value of currencies can vary considerably in the short term. Over the last three decades, the PPP value of our dollar has oscillated fairly tightly between US$0.80 and US$0.85, yet there have been long periods of time when the exchange rate was either well below or well above that range.
In the late 1990s and early 2000s, the Canadian dollar was severely depressed around US$0.65. Interestingly, during that period many Canadians were buying extremely expensive blue chip American stocks because they had outperformed their Canadian counterparts in the recent past and because investors were concerned that the Canadian dollar would fall further. At the time, we advised clients to keep their money in Canada because domestic stock valuations were much better, the resource sector was overdue for a rebound and the exchange rate was depressed.
In the lead-up to the 2008/09 financial crisis, our dollar rallied well above PPP and exceeded par for some time, largely due to the China-led resource boom. Consequently, the resource-geared Canadian stock market was very popular and richly priced. Blue chip American stocks were comparatively much cheaper, yet few Canadians wanted to take advantage of our overvalued dollar and the bargains south of the border.
The exchange rate crashed back to its PPP level for a brief period during the crisis, but quickly rallied through par and stayed near that level until 2013. Nonetheless, Canadians were again reluctant to take advantage of our strong dollar and purchase out-of-favour U.S. securities during that period. Since 2013, the value of our dollar has trended back to PPP in the face of sluggish global growth and correspondingly weak commodity prices.
While the exchange rate has both hurt and helped the returns on U.S. stocks at times over the last decade, investors who diversified outside the country have been well served. Since the end of 2006, and through to mid-August 2017, the broadly based U.S. S&P 500 Index has produced a total return of 118% in local currency terms and 139% when translated into Canadian dollars, more than double the 59% return for the Canadian S&P/TSX Total Return Index.
Resource stocks have struggled in recent years due to the tepid nature of the economic recovery. The Canadian stock market is considerably more cyclical than the U.S. stock market, and hence it tends to underperform when growth is slow.
At this juncture, eight years into the post-2008/09 financial crisis recovery, we are neither excited nor worried about the economic outlook. Consequently, we don’t expect the exchange rate to stray far from PPP over the next 12 months. Over the medium and long term, we believe there is more downside risk than upside potential for the exchange rate. From an economic perspective, Canada is more vulnerable to a deeper economic cycle given the country’s high level of consumer debt and frothy housing market. Beyond the cyclical horizon, we think the U.S. has structural advantages that should translate into a relatively stronger economy and U.S. dollar. Moreover, Canada’s above-average gearing to cyclical businesses could continue to weigh on relative returns in a slow-growth world.
We are not in a hurry to repatriate money back to Canada and remain comfortable with considerable equity exposure outside the country. Quality is paramount late in the economic cycle and in a slow-growth world, and it’s simply easier to find reasonably priced high-quality businesses beyond our borders.
1 The Odlum Brown Model Portfolio was established by the Research Department in December 1994, with a hypothetical investment of $250,000. These are gross figures before fees. Past performance is not indicative of future performance. Trades are made using the closing price on the day a change is announced.
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