Loonie forecasting

As an advisor you often encounter clients anxious to know whether they should diversify internationally. While more and more Canadians are looking at overseas opportunities, for the most part, even if the investment they are contemplating is based in one of the strongly emerging economies, they are usually interested in acquiring U.S.-denominated instruments. Your advice will turn you into a currency forecaster. Specifically, you will be forecasting the U.S. dollar value of the loonie.

Avoid the temptation to run for the hills. It’s not that exchange forecasting isn’t a daunting challenge, it is. In fact it’s an impossible one—but it is impossible for everyone. If you doubt that, consider that in the late 1990s many Asian economies offered very attractive opportunities. Every major global investment bank had substantial offices in cities like Jakarta and they retained high-priced talent to observe and predict currency risk. In 1997, the Indonesian rupiah was trading around 2,400 to the U.S. dollar. As the 1998 Asian financial meltdown manifested itself in just a few short days, the currency collapsed to where it took 13,000 rupiah to buy a dollar. Nothing had changed other than perception and contagion, but when they shifted, all the overvalued prognostications went out the door.

Against such cataclysmic swings, changes in U.S., Canadian dollar rates seem relatively inconsequential. Still, with Canadian markets broadly emulating US markets, getting the direction of the exchange rate wrong can make an impact on comparative returns. So, if you can’t provide definitive guidance, you should at least be convincing.

It may not help your confidence much when you consider that within the past decade the Canadian dollar has touched modern era lows and highs—at one point threatening to touch 50 U.S. cents to the loonie and at times within the past several years trading at a considerable premium.

Although accurate currency forecasting is impossibility, you can still sketch a central tendency. You can provide a logical framework around which you and your client can construct a sensible currency strategy but before we add some bones to that skeleton it might be worth digressing to consider what we (i.e. Canadians or specifically your client) would like the dollar to do, overlooking the obvious that those who may have already heavily invested in the U.S. want the loonie to slump so as appreciate their Canadian-valued portfolio. The trouble is that most Canadians, much of the media and a great many bureaucrats and politicians, demonstrate a good deal of ambivalence about the dollar.

In the early 2000s when the loonie was mired at an epic low against the U.S. dollar, commentary reflected public embarrassment with its eroded value. It was seen as a reflection of just how deeply Canada’s economic fortunes had sagged. Well, a lot has changed since then. Strong fundamentals have been reestablished and maintained: a determined anti-inflation policy; a more disciplined fiscal stance than that in the United States; and until recently, a persistently positive trade balance.

Fast forward to today. Since the 2002 episode, commodity prices have soared and with them the loonie has surged. True we have passed through a gut-wrenching correction since the 2007 peak but materials price growth is reemerging and the dollar has again started creeping towards parity.

What has been the response? The Prime Minister recently cautiously reinforced concerns voiced by Bank of Canada Governor Mark Carney that the dollar’s appreciation would dampen the recovery. Subsequently, the Bank went a step further, triggering a sharp correction in the dollar by suggesting that the appreciation would: “…more than fully offset the favourable developments since July.” The downward impact was short-lived, and with dubious global investors remaining tentative concerning the U.S. greenback, the loonie is once again on the ascendancy.

Relative to the rest of the world, Canadians collectively receive a pay raise every time the dollar appreciates but judging from the baleful official pronouncements, one could be forgiven for thinking that it was bad news. It isn’t. It means that Canada can command a greater share of global output in exchange for giving up less of its own.

Clearly the powers that be believe that the economy would be better served if the exchange rate weakened. Would it? It is true that profit margins for exporting manufacturers come under increasing pressure when their U.S. dollar sales are converted into local currency but a depreciating or devalued currency would only serve as a short-term palliative. To see that, one has only to consider how three decades of term depreciation of the U.S. dollar against global currencies has done nothing to improve U.S. manufacturing competitiveness and, in fact, has coincided with the gradual attrition of the U.S. manufacturing sector.

The reality is that Canada, along with other highly developed countries, no longer enjoys a global comparative advantage in manufacturing and that is reflected in the dwindling contribution of the sector to gross domestic product and employment. The entire manufacturing sector now constitutes less than 15% of the Canadian economy.

Of course, many services are difficult to export so manufactured goods are necessarily a more significant contributor to the trade balance. Even so, they amount to only about one-half of our merchandise exports. Periodic surveys conducted by the Bank of Canada during previous periods of currency appreciation confirm that it is producers of those products that are predominantly impacted when the dollar strengthens.

Commodities make up the other half of merchandise exports. Resource company’s margins are also squeezed by appreciation but the impact is offset by the substantially higher product prices that fuelled the loonie’s rise in the first place. By far the greater part of the economy benefits from a stronger dollar. Retailers and commercial suppliers trading in imported goods experience lower costs that may be passed along to consumers or added to margins. Even manufacturers themselves benefit from lower-cost imported machinery as well as cheaper imported components built into their products. Resource companies in addition to enjoying higher product prices are also assisted by from lower equipment costs and certain service costs. The loonie’s strength benefits individual Canadian consumers every time they shop or vacation.

So how do you put all this into perspective for your clients? Their concerns are not what is good for the country but what is best for themselves. If they are considering a purely U.S. trade (as opposed to U.S. market instruments of an overseas entity) you may want to advise them that the consensus view is that the loonie is more likely to continuing appreciating, albeit likely only modestly. To convince them, you can quote the exchange rate projections most commercial banks prominently maintain on their websites or even point to the inherent expectations of central bankers and politicians anxious to dampen the pressure.

You can also lead them through a simple series of questions: Do you believe that Canada’s fiscal position will likely continue to be stronger than that of the United States (taking into account the headlong lurch into massive U.S.stimulus on top of years of fiscal profligacy)? Do you believe that Canada is at greater or lesser risk of inflationary pressures than the United States? Do you believe that industrial economies have shifted into the early stages of recovery (and in consequence demand for Canadian commodities will likely improve)? Do you believe the role of the U.S. dollar as the international reserve currency has been steadily eroding?

If your client gives a positive response to those questions then he/she has implicitly formulated their own forecast, in agreement with those consensus-hugging professional economists. The conclusion: by all means diversify internationally but don’t expect to make a quick buck on the buck.