Last year wasn’t a great year for investors. In Canada, the S&P/TSX Composite Index was down 11%, with the energy sector responsible for more than one-third of that decline, thanks to lower oil prices.
However, it wasn’t all bad news for Canadians when it came to lower oil prices. The energy industry is such a large contributor to the Canadian economy that movements in the price of oil tend to affect the exchange rate between the Canadian dollar and the U.S. dollar. In fact, the Bank of Canada uses only three main factors when predicting how the loonie will fluctuate relative to the greenback: purchasing power parity (“PPP”), interest rates, and oil prices.
Thus, as oil prices fell, so too did the value of the Canadian dollar relative to the U.S. dollar. While this was unfortunate for Canadians who wanted to go shopping in the U.S., it was great news for Canadians who were invested in U.S. assets. Take the S&P 500 Total Return Index for example. In U.S. dollar terms this index fell 4.4% in 2018. In Canadian dollar terms, though, this index actually increased 3.7%. This is because it cost Canadians CAD$1.25 to buy US$1.00 at the start of 2018, while they would have received CAD$1.36 for each US$1.00 they held at the end of 2018.
Where does the loonie go from here?
Foreign exchange rates are notoriously difficult to forecast. It is for this reason we don’t hedge our FX exposure in our funds. Over the long-term, we are of the view that Canadian dollar appreciation and depreciation versus other major currencies will even out. Additionally, hedging costs money, so we don’t want to spend your investment capital if we don’t have a strong view on what it’s going to accomplish.
That said, we do have qualitative views on what the Canadian dollar will do. Of the three main factors affecting the exchange rate – PPP, interest rates, and oil – we think interest rates have the most future visibility. This is because rate movements are largely tied to the strength of a country’s broad economy. When things are going well, central banks tend to raise interest rates, and vice-versa.
To clarify, it’s not just the absolute value of interest rates that affect the exchange rate. Instead, it’s the difference in exchange rates between two countries. Debt issued by either the Canadian government or U.S. government is considered to be risk-free in the eyes of investors. Thus, similar fixed-income securities with similar risk profiles should have similar yields. If, hypothetically, the Bank of Canada was to cut interest rates, while the U.S. Federal Reserve was to increase interest rates, investors would be drawn to the U.S. government securities that had higher yields. As a result, demand for the U.S. dollar would increase relative to demand for the Canadian dollar. This would cause the U.S. dollar to appreciate in value relative to the Canadian dollar. This historic relationship between rates and FX is illustrated in the following chart.
We think the relative difference in interest rates between Canada and the U.S. has higher predictability than oil or PPP because of the risks looming in each of the two economies. The U.S. economy is far from perfect: we believe the historically-low unemployment rate and an abundance of cheap money means the country is at risk of overheating. But these concerns pale in comparison to what we see in Canada.
We’ve discussed the risks facing the Canadian economy before. To recap, both consumers and businesses are carrying very high levels of debt. We believe this is going to put a ceiling on how much the Bank of Canada can raise rates before it has a serious impact on the economy. As a result, the Federal Reserve, which seems to be in the middle of a rate-hike phase, is apt to raise U.S. rates higher than what we’ll see from the Bank of Canada.
If that turns out to be the case, the Canadian dollar would depreciate versus the U.S. dollar. In such an environment, we believe it would be wise for investors to maintain significant exposure to U.S.-dollar-denominated securities. As it stands right now, the Cowan Absolute Return Fund has 21% exposure to the U.S. versus 42% to Canada and the Cowan Income Opportunities Fund has 20% of its holdings in USD securities, with the rest in CAD. We are comfortable with these weightings, in part because of the aforementioned risks facing the Canadian economy.
What if we’re wrong?
Forecasting the economy is extremely difficult at the best of times. We will be the first to admit that our predictions could prove to be well off base. If that turns out to be the case, what does that mean for our funds?
Over the short- and medium-term, the funds would likely have FX movements work against it. If the Canadian dollar was to appreciate versus the U.S. dollar (as it did in January), our U.S.-dollar-denominated holdings would put downward pressure on the funds’ net asset values, which are priced in Canadian dollars.
But over the long-term, we are content holding a great deal of the funds’ assets in U.S. securities. The U.S. continues to be the biggest economy in the world, with roughly 10x the investment opportunities of Canada. Even if we’re wrong on our FX bet, we don’t think we’ll be wrong about betting on the long-term health of the U.S. economy.
Furthermore, we like diversifying our holdings outside of Canada, whose markets are dominated by oil & gas, financial, and mining companies. In 2018, 83% of the S&P/TSX Composite’s decline was caused by those three industries. There’s a lot more contributing to the global economy than just extracting commodities and providing bank loans.
As Canadians, we don’t like seeing oil prices decline. Nor do we like seeing our economy being powered by over-leveraged consumers. But we are realists, and we will manage the funds accordingly. If that means a greater exposure to businesses located outside of our borders, so be it.