Mutual fund statistics show Canadian investors have been pulling out of foreign equity funds as the Canadian dollar has surged upward and hurt returns for these funds in the past couple of years.
This appears to have been the right choice to date, but with the Canadian dollar so high that it is inflicting pain on Canadian business, there are two good reasons why investors should now be looking to increase the foreign content of their portfolios.
First, the upward climb of the Canadian dollar is most likely over and it will no longer damage returns on foreign investments as it has for the past two years. As an example, the S&P500 index rose 28.7 per cent in 2003, but in Canadian dollars the rise was only 6.2 per cent. In the first 11 months of 2004, the S&P500 was up 7 per cent but in Canadian dollars it was down 1 per cent.
The Canadian dollar recently topped out at 85 cents (U.S.) and it is significant that it did not make new highs as the Euro, British pound and Japanese yen made new highs against the U.S. dollar on disappointing U.S. employment statistics in the first week of December. If the Canadian dollar was going to continue to soar, it would have done so with the other currencies. Instead, it hung around 84 cents (U.S.).
The 30-per-cent rise in the Canadian dollar in the past two years – from 65 to 85 cents (U.S.) – has hurt many Canadian businesses. With the way the economy works in lags, the damage didn’t show up until recently.
But now with plenty of evidence that exports are falling and layoffs have started in the dollar-sensitive manufacturing and tourist industries, the Bank of Canada has taken notice and is likely to manoeuvre interest rates in such a way that the Canadian dollar doesn’t go any higher.
It is most likely that, to avoid a further appreciation of the Canadian dollar, Canadian interest rates will drop down to or below U.S. rates to discourage capital inflows in the months ahead. Even with the expected dollar-stimulated productivity improvements, the economy just can’t afford to have a Canadian dollar at 90 cents (U.S.) or higher.
It wouldn’t take much for Canadian interest rates to drop below U.S. rates. The Canadian 10-year Government of Canada bond yield in early December was 4.34 per cent, versus 4.26 per cent for the U.S. 10-year Treasury.
This scenario is not guaranteed. If inflation surges in Canada, the Bank of Canada will have no choice but to raise interest rates much further and that could precipitate another boost to the Canadian dollar. However, with inflation remaining subdued, that’s unlikely. But even if it were to happen, it would be for only a very short period of time as it would become clear to all, as recession developed, that the Canadian dollar was too high.
Second, with Canadian businesses feeling the effects of high energy prices and the high Canadian dollar, investment returns from Canadian stocks are likely to be meagre in the coming year or two. Even oil and gas and mining stocks, which have shown great returns for two years, may stall as commodity prices stabilize or correct downward somewhat.
In addition to the effects of the surging Canadian dollar, Canadian manufacturing exporters are also facing severe competition from China where high tech has merged with low wage rates to produce an economic powerhouse that is overwhelming anything that stands in the way.
In this context, it makes sense for Canadian investors to seek investment returns from global companies that can take advantage of the China situation (locating plants there or buying their low-cost goods), rather than being knocked over by it.
That, of course, means diverting more investment dollars into foreign stocks, either directly or through international equity funds.
Fund managers who can move money around the world to take advantage of all good opportunities are likely going to produce better longer-term returns than those concentrating on a single country.
This reasoning was behind the investment community’s push a few years ago to raise the foreign content limit for RRSPs and it remains valid today.
Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.
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©2004 Wayne Cheveldayoff