Why loonie bulls should be cautious
Stronger dollar could have dampening effect
Despite all of the hype around new market highs, equity markets for the most part lost a bit of momentum in the second quarter.
In Canadian dollar terms, the MSCI World Equity Index gained only 1.3 per cent last quarter compared to the S& P 500 that gained only 0.4 per cent while closer to home the S& P TSX lost 1.6 per cent. A global balanced portfolio with a 60/40 equity- to- bond split gained only 1.2 per cent in the quarter while a Canadian balanced portfolio lost 0.5 per cent.
Besides collapsing oil prices, the story of 2017 has been the falling U. S. dollar as it has pulled back to levels prior to the election of Donald Trump as investors have been unwinding the whole Trumpflation trade.
In particular, many no longer believe that President Trump will be able to implement a lot of his inflationary tax and fiscal spending policies that in turn would cause the Federal Reserve to accelerate rate hikes. At the same time, global central banks including our own Bank of Canada have started implementing tightening policies of their own which have further supported their local currencies.
When combined, t he magnitude and depth of the selloff has been quite impressive, with the U.S. Dollar Index (DXY) falling by nearly seven per cent this yearto-date. According to Charlie Bilello at Pension Partners, every major world currency has rallied against the U. S. dollar this year gaining on average 3.5 per cent to over nine per cent.
The loonie is right in the middle of the pack with a six per cent gain this year- todate. Interestingly, it was only up 3.6 per cent in the first half of the year with most of the gains coming on the back of the Bank of Canada’s sudden hawkish policy move over the past two weeks.
This means that those Canadians that held foreign assets in U. S. dollars saw their returns dampened by the currency move. For ex- ample, the S& P 500 is up nine per cent in the first half of the year but in Canadian dollar terms it was up only 5.2 per cent. That said, this is still better than the S& P TSX’s flat return profile of 0.7 per cent.
Looking ahead, one shouldn’t necessarily celebrate a stronger loonie as when combined with higher interest rates as it could have a dampening impact on our economy. We remain especially worried about our nation’s over- reliance on housing while oil prices have fallen by nearly 15 per cent this year — something most pundits for whatever reason don’t seem too worried about.
From a fundamental point of view, we wonder how much upside the loonie has from here as it appears to be pricing in another rate hike this year. Our rationale is that we think the move by the Bank of Canada was more politically motivated t han anything else and meant to slow down the booming housing market as the recently imposed tighter lending standards so far have had little effect. A higher loonie should have a direct impact on foreign buyers of properties as they may very well decide to buy in California instead of British Columbia or New York instead of Ontario.
Having just returned from a summer vacation south of the border, I couldn’t help but observe just how strong the U. S. economy really is compared to ours — and yet its currency is falling against the loonie. This was quite the difference from the mid2000s, when the commodity boom drove both the Canadian economy and its currency higher against the U.S.
In my opinion, this disconnect presents an excell ent opportunity f or the contrarian out there and especially for those lacking in international diversification. Therefore, rather than speculating on currency moves, instead we look at the stronger loonie as a way to make U. S. goods including their equity market that much less expensive. Bon voyage.