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October 1, 2007
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A Canadian Dollar Story
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For global investment managers this has been a particularly challenging period. You make good investment decisions but end up with single digit returns, when investors are bombarded with stories about how the markets are setting all time highs. In reality this distortion rests squarely at the feet of a remarkable Canadian dollar story. The rise in the loonie while good, has distorted all levels of performance numbers.
For example, we hear every day how oil is setting all time highs, trading well above US $80 per barrel. Its highest price by a wide margin. Yet, the price we pay for gas at the pump is below Cdn $1.00. Still expensive, but well below the $1.10 to $1.15 paid at the pump last year, when oil was trading at much lower levels. How is that possible?
It again comes down to the Canadian dollar. In terms of the Canadian dollar, oil prices have not gone up. In fact, in Canadian dollar terms, the price of oil is actually below where it was at the beginning of the year.
You could argue, which many analysts have, that oil prices continue to climb in response to headline grabbing comments about surging world demand. Yet in the same breath, we hear that oil producing nations are not working to capacity, and that world economies appear to be slowing. Some have gone so far as to suggest recession. How do such conflicting views encompass the financial landscape?
In my opinion, most of what we are seeing in the commodity and financial markets can be explained by the weak US dollar. In much the same way as your brokerage statement’s performance numbers may not seem to jive with reality, when in fact they are reality, which simply does not jive with investor’s perception.
Expect more of the same in the weeks ahead. The new Governor of the Bank of Canada will be hard pressed to lower interest with our economy moving along at such a brisk pace. Unemployment dipping below 6% for the first time since the mid-1970s. Those are numbers that could lead to inflationary pressures, and the Bank of Canada knows this.
On the other hand, we can be reasonably assured that the US Federal Reserve will lower rates by at least another 25 basis points. The Fed has been working behind the scenes in the boardrooms of financial intermediaries making certain bankers understand the importance of full disclosure as to the extent of their exposure to sub prime debt. Citigroup’s US$5.6 billion write down was just the beginning. More will come this month.
But with bankers like Citigroup being so forthcoming - wonderful how the risk of spending time in jail gets one focused on the merits of full disclosure – it would not be surprising to see the Fed make another move. If nothing else, a reward for good behavior.
Combine those two positions (lower US rates, stable Canadian rates) and the Canadian dollar could well see US $1.05 before year end. Making it one of the most remarkable rallies in currency history. Certainly in terms of the relationship between Canada and the US. For Canadian investors, it means that good performance in foreign securities will be negated almost entirely, by a rising Canadian dollar.
Is the answer is to avoid foreign securities in favor of Canadian companies? To some extent yes. As a global investor, I certainly want to hold an over-weighted position in Canadian stocks. But over-weighted against what?
A conversation about portfolio weighting brings the Canadian dollar story full circle. The problem with most of us, is that we get caught up in the headlines, often preventing us from seeing the forest for the trees.
It causes us to re-evaluate and sometimes alter, what is a grounded approach to investing. Why? Because we cannot bridge a gap between a position that global diversification adds value, with one that says global investing underperforms.
I liken it to someone in the middle of a desert. Under the scorching heat, you look around and see nothing but sand for miles. You don’t know where you are, where you are going or where your have been. It’s the same with an investor looking at performance results, believing they should be doing better, but without knowing why.
In the desert, we would pound a stake in the sand and walk away from it. The moment we do this we now know three things we didn’t before. We know where we have been, where we are now, and how far we have come. That’s what investors must do, if they are trying to evaluate a strategy that has of late, not been very successful. At least with the stake-in-the-sand approach you have a methodology to engage in a proper review.
I’ve talked about this before. In the investment business its known as a benchmark. It addresses questions like; are oil prices are up? Or are oil prices are stable? It depends on your benchmark.
If you are really interested in what it costs you to buy gas at the pump, looking at the price of oil in US dollars does nothing to help you gauge where gas prices are likely to go.
In the same way, if you believe that global diversification adds value to a portfolio, then your stake-in-the-sand ought to recognize that. In this case, your stake is a benchmark that includes US and EAFE assets along with Canadian assets. Your benchmark should always be translated back into Canadian dollars, so that you have an apples to apples comparison with your portfolio returns.
If your benchmark says that 50% of your portfolio should be invested in US and EAFE assets and 50% in Canadian assets, then you have a stake against which to measure your over-weighted or underweighted position in a particular market. If you think that you should be over-weighted in Canadian equity – probably a good idea - an over-weighted position would be one in which you have greater than 50% of the portfolio in Canadian assets. No one in which you throw out a global strategy because of short term noise.
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