The dollar dilemma returns

Being at par with the U.S. dollar was good while it lasted, but, as many economists had predicted, the Canadian dollar has finally started to come back down to earth.

Whenever our dollar is worth more than its U.S. counterpart, the Canadian psyche gets a boost. This was the case back in the 1970s when the Canadian dollar traded in the $1.04 U.S. range and again more recently, when the dollar topped out at $1.05 U.S. in July 2011. We get a swagger in our collective step when we travel to the United States and see how much further our dollars go. We get frustrated when retailers aren’t quick enough to reflect our newfound currency superiority in their prices. But deep down, there’s also a sense that sooner or later our dollar will give way to the currency of our neighbour to the south. If you were following the dollar debate among economists recently, you knew that it was likely only a matter of time.

Why down now?

Beginning in 2013, the Canadian dollar really began to slide, losing 6.6% before the year ended and by the end of the first quarter of 2014, it was down a further 3.9%, dipping below 90 cents U.S. – the lowest level since July 2009. There are two key factors behind the dollar’s downturn. First, the U.S. currency is strengthening, and not just against the Canadian dollar but against many currencies. The surge in the U.S. dollar is partly due to an expectation of accelerating U.S. economic growth, and partly due to the increased demand for U.S. dollars as investors move out of emerging markets in a flight to quality. Secondly, the downturn in materials prices and Canada’s overall weaker economic conditions have put downward pressure on our currency relative to the U.S. greenback.

Is 90-cents U.S. the sweet spot?

While the Canadian dollar was flying high, most economists were declaring that it was overvalued. They reasoned that on a purchasing power parity basis, the dollar’s value was not reflective of what it could buy relative to other currencies. Comparison shopping in the U.S. shows that goods generally cost more here and The Economist’s Big Mac index confirms this. If our currency were truly worth more, we would be paying less for a Starbucks latte than our American neighbours. Instead, we pay more. A lower Canadian dollar will increase the prices of imports for Canadians, but it will also be a boost to our export industries, particularly the hard-hit manufacturing sector. Still, no one wants to go back to a Canadian dollar worth only 63 cents U.S., as happened in 2002. A dollar trading around the 90 cents U.S. mark is widely thought to be optimal – not so low that import prices become inflationary and not so high that it hurts our export market.

Foreign holdings get a boost

Although the ups and downs can be dramatic in the short term, currency fluctuations tend to level out over longer periods of time and the impact on investment portfolios is more muted. However, in the short term, changes in currency values can affect the value of investment holdings denominated in other currencies. As share prices are converted from the local currency to Canadian dollars, investors will gain or lose depending on whether the Canadian dollar has appreciated or depreciated relative to the foreign currency. Currently, the depreciation of the Canadian dollar is giving a boost to returns on foreign holdings, just as it did when the dollar declined in the late 1970s and through most of the 1990s. At the end of the first quarter 2014, in local currency terms, the return from the S&P 500 index was 1.8% compared with 5.8% in Canadian dollar terms – a difference of 4%. However, when the Canadian dollar appreciates, Canadian investors experience a negative effect on the returns of any investments denominated in foreign currencies, as was the case from 2003 to 2012.

Balanced portfolio provides a hedge

The effect of currency fluctuations on portfolios generally diminishes over time and, in our experience, the cost of currency hedging overshadows any benefit achieved over the long term. By adhering to our clients’ investment policy statement and maintaining a balanced portfolio suited to their needs and goals, we are creating portfolios that provide some measure of currency hedging, at no additional cost, through asset allocation.

A typical balanced portfolio has about 60% of its assets denominated in Canadian dollars and around 40% in foreign currency, thereby limiting the impact of changes in the value of the Canadian dollar on portfolio returns. As well, rebalancing tends to mitigate some currency effects by restoring currency exposure. When Canadian dollar depreciation augments the performance of international securities in the portfolio, the risk associated with any subsequent appreciation of the Canadian dollar is diminished when the allocation to foreign holdings is reduced through rebalancing. Currency risk comes with investing outside of your home country but, over the long term, it is outweighed by the benefits of international diversification.

How much is that Big Mac?

When The Economist introduced its Big Mac index in 1986, it was in their words “a lighthearted guide to whether currencies are at their ‘correct’ level.” The index, which reports the price of a Big Mac in more than 50 countries, is based on the concept of purchasing power parity. Purchasing power is a measure of what your money will buy. Purchasing power parity compares the buying power of different currencies on a common basket of goods or in this case a single item, the Big Mac.

McDonald’s Big Mac is available in 120 countries making it an easily recognizable point of comparison around the world. Setting the U.S. dollar as the base currency on the index will show how the price of McDonald’s signature sandwich in other currencies compares with the price in the U.S. The idea is that as a currency achieves purchasing power parity with the U.S. dollar, the price of the Big Mac would be about the same. But when a Big Mac costs more, the currency is reported as overvalued relative to the U.S. dollar and when it costs less, the currency is considered undervalued. The January 2014 Big Mac index reports the Canadian dollar as being overvalued by about 8% with a Big Mac going for $5.54 in Canada ($5.01 in U.S. dollars) compared with $4.62 in the United States. Purely on the basis of “Big Mac index theory,” it appears that the Canadian dollar has room to depreciate further.

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These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information. No endorsement or approval of any third parties or their advice, information, products or services should be implied by any references to third parties contained in any article. Trademarks cited in these articles are the respective properties of their owners.

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