Investors must pay more attention to exchange rates, says TD

(February 10, 2004) U.S. equity markets delivered stellar returns in 2003. But Canadian investors missed out on much of those gains due to the loonie, which surged 20% last year against the greenback. Exchange rate considerations must become an integral part of the investment process, says TD Economics in a report released today.

“The most obvious and immediate impact of the stronger currency has been to reduce the financial returns received by Canadians from their foreign investments, particularly U.S.-dollar-denominated assets,” the report states.

“Investors will have to put more weight on exchange rate considerations in their decision toolkits,” added TD chief economist Don Drummond.

Canadians have been encouraged to hold foreign investments in their portfolios, TD says, noting that since the foreign content limit was raised to 30% in 2002, Canadian holdings of foreign stocks and bonds have increased dramatically. About 60% of that foreign allocation is in the U.S. market.

When the loonie was weak, Canadian investors benefited. For example, a 10-year U.S. government bond purchased in 1991 earned an additional 27% return because of the Canadian dollar’s depreciation over that period.

But there’s a new reality. A U.S. equity mutual fund that replicated the performance of the S&P 500 delivered a total return of 28% in 2003. Taking the exchange rate into account, Canadian investors saw only a 6% return.

Still, for most Canadians, the impact of the rising loonie on their personal investments was modest, TD says. Most individuals do not maximize their 30% foreign content limit. “Accordingly the strengthening in the Canadian dollar is likely to have reduced returns on portfolios by less than five percentage points in 2003.”

TD expects the loonie to finish 2004 at around 79 cents US, a 5% gain. That means the foreign exchange impact on Canadian portfolios in 2004 should prove “quite limited.”

A strong dollar also affects domestic investments, TD says, dampening corporate profit growth and “constraining the upside on equities.”

In addition, a higher currency tempers inflation, ultimately depressing the rate of return on money market investments and limiting the rise in bond yields, TD says.

“All of these trends will remain in place, but will be less pronounced in the coming year.”

The report, called “Loonie Tunes — Understanding The Rally In The Canadian Dollar And Its Consequences,” also estimates the currency’s impact on the economy, predicting that a stronger loonie will shave close to two percentage points of real GDP growth in 2004.

Filed by Doug Watt, Advisor.ca, doug.watt@advisor.rogers.com