Terms of Trade: Factoring Currency Implications In Your Investment Decisions
The Bank of Canada has an excellent webpage that can help investors understand what factors move the Canadian dollar. Canada is about 3% of the equity world and about 5% of the bond world, so the majority of investment opportunity resides in foreign currencies. This leads me to discuss the biggest investment factor in portfolios: currency returns. Since the world left the gold standard in 1971, the annual impact from currency movements has been in the 5 to 10 per cent range depending on the country. I know, most investors do not consider this at all, but it’s at least as large as the average price change in assets (stocks and bonds).
So what makes a currency move? There are two trade accounts that govern the types of money flowing. What is known as the current account and the capital account. The current account include things like difference between imports and exports of goods and services. This is known as the balance of trade. The capital account deals with longer-term investments like securities (stocks and bonds), but also long-term investment. For example, a foreign corporation building a manufacturing facility in Canada. It creates jobs (and taxes) here, but the profits tend to flow back to the foreign country. Or in the case of a Canadian buying AAPL (Apple) trading on the NASDAQ. With all of these types of transactions, there is a net amount of money flowing in or out of the country.
When a government runs a balance of payments deficit, there is more money flowing out and the currency will tend to weaken. Canada used to be a big supplier to the US auto sector and our largest export remains energy products. Our export competitiveness is a major factor. A weak currency makes our exports cheaper. In 2019, 22% of Canadian exports was mineral fuels (oil & gas) and vehicles 13.8%. When president Trump wants more jobs in the US and says all his trade deals are bad, this is bad for Canada. Canada is a big exporter of steel and aluminum too, but neither make the top 10 category. Incidentally, gold exports (about 5%) are on the rise as the dollar value, not the quantity are rising.
Over the past 20 years, we see that Canada is less reliant on the US economy for capital flows, but it will always remain the biggest piece. The biggest increases are China, Europe and Mexico.
This leads us to our Call for the week. The recent strength in the Canadian dollar is not at all due to improving trade outlooks for Canada (beyond some price increases in commodities). It’s it not at all due to an improving fiscal outlook or an improving business climate that would attract foreign investment. We are past the best before date in the energy sector due to lack of government support for investment in our largest export sector and possible global peak demand. It has got caught up in the general reduction in “flight to safety” flows in the US dollar. And that has occurred, in part, because the US is doing so much worse in terms of battling COVID, election uncertainty, and the massive debasement of the dollar as the Fed’s balance sheet is expanding at lightening speed. We see the Canadian dollar weakening back below 70 cents (1.4286) over the next year and therefore we would look to own those US assets (ETFs) without a currency hedge. Weakness is terms of trade and our overall economic outlook are not bullish. DLR is the Horizons’ US dollar money market ETF that gives exposure to the US Dollar. If you are sitting in cash because you are worried about elections or market valuation risk, consider sitting in the US dollar.
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