What to buy when the loonie is high

And now ladies and gentlemen, boys and girls, please direct your attention to the centre ring and lift your gaze skywards. Get ready to be dazzled. Be prepared to wonder. Get set for the thrill of a lifetime. Now performing, with no safety net, on the high wire and the super trapeze, introducing (drumroll please) the astounding, high-flying, gravity-defying star of our show, ladies and gentlemen, boys and girls, put your hands together and give a rousing welcome to The Amazing Loonie!

Okay, so our dollar hasn’t yet been recruited by Ringling Brothers but if things go on this way much longer, it soon will be. With the Iraq war and the Toronto SARS crisis behind us, the flight of the loonie has been the number one financial story, dominating the TV newscasts and the newspaper headlines. For a while, almost every day brought another new high, and our currency is now at levels we haven’t seen since 1997.

Experts amazed
The experts are flabbergasted. No one that I know of predicted the Canadian dollar would crack through $0.73 this year. Our currency ended 2002 at US$0.6339. While many economists felt the U.S. dollar would weaken in 2003, few pected the loonie would even make it to US$0.70. BMO Financial Group chief economist Dr. Sherry Cooper was quoted in The Globe and Mail on New Year’s Day as saying that while the Canadian economy outperformed in 2002, “the Canadian dollar eked out a mere 1.2 per cent gain, despite the best economic fundamentals in the G7.”

She went on: “This does not bode well for 2003, although we continue to expect the [Canadian dollar] to rise, at least temporarily, to above 66 cents.”

Well, US$0.66 has long come and gone. Now economists are boldly talking about the prospects for the loonie hitting US$0.80 or even US$0.82 within a year. I have yet to hear of anyone predicting a retreat to below US$0.70.

What are we to believe? The plain truth is that experts who have been trained at the world’s best economic schools and have spent years studying currency movements haven’t a clue as to what will happen a few months down the road. In fact, most of them can’t even tell us with any degree of certainty what will happen next week.

Loonie likely to slip back
I have always said that currency movements are notoriously unpredictable, which is why I always respond to questions about where the loonie will be six months from now with a simple: “I don’t know”. If that makes me appear stupid, then I am in good company. Only a time-traveler could answer that question accurately. My guess, and it is only that, is that the loonie will continue to gain in value over the short term but will eventually slip back to the US$0.70 range as the Canadian economy loses steam (which it likely will because of the higher cost of our experts) and the interest rate spread between Canada and the U.S. narrows.

I have long maintained that the best way for ordinary investors to protect themselves against a wildly fluctuating loonie is to hedge their bets by allocating a percentage of their assets to other currencies. Right now, that approach is working against us, especially if the other currency is U.S. dollars. But back in the not-so-distant past, when the loonie was hovering around US$0.61, this type of hedging was a life-saver to anyone who needed U.S. dollars. So I make no apologies for advising this strategy. In fact, if you expect to need U.S. dollars in the future, you may want to increase your holdings gradually over the coming months while greenbacks can be purchased at fire-sale prices.

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Currency hedging aside, the rapid rise of our dollar has some other important implications for investors and you need to be aware of them in making buy-sell decisions in the coming months. They include:

Except lower returns on U.S. securities
Lower returns on U.S. securities. According to my calculation, the loonie has gained about 15 per cent so far this year. If you own any U.S.-dollar securities, that means they must have increased in value by that amount for you to be at the break-even level in Canadian dollar terms. Of course, very few have. You can easily see the impact of the rising loonie by looking at the performance numbers of mutual funds that are sold in both Canadian and U.S. dollar units. Take the AIC American Advantage Fund, for example. In the 30 days to May 16, the U.S. dollar units of this fund gained an impressive 6.74 per cent. But now look at the Canadian dollar units. They barely broke even, with a marginal gain of 0.15 per cent. That’s not an isolated example. The U.S. dollar units of CI American Landmark Fund scored a huge 30-day gain of 13.33 per cent. But the Canadian dollar units show an advance of only 6.33 per cent. In other words, the nice gains we’ve seen in the American markets in the past month have been largely negated by the rise in the value of the loonie.

Energy trusts vulnerable
Reduced oil and gas trust distributions. Most income trust investors aren’t aware of the fact that a rising loonie can mean reduced distributions for them if a large portion of the trust’s business is U.S.-based. The energy trusts are particularly vulnerable, since oil and natural gas are priced in U.S. dollars. This means that as the loonie climbs, the trusts (and oil companies) effectively receive less money for the products they sell. Pengrowth Energy Trust, for example, estimates that for every penny the Canadian dollar rises, its distributions are potentially reduced by about three cents annually. With the loonie up about US$0.10 this year, that could translate into a C$0.30 decline in distributions. Currency hedging programs may soften the blow, but if our dollar stays high for any period of time, shareholders will inevitably feel the effect. The result could be a weakening in the market price of these trusts that has nothing at all to do with the international price of oil.

Foreign acquisitions
A more aggressive approach to foreign acquisitions. A high loonie should encourage cash-rich Canadian companies to seek out acquisitions abroad while they can be had at cheaper prices. We’re already seeing some signs of that this is happening. Recently, Vincor International announced the purchase of a prestige New Zealand winery. There is media speculation that Manulife Financial, which missed out on its bid for Canada Life, may turn its attention to the big John Hancock company in the U.S. Expect more reports of this kind in the months ahead.

Stick close to home
My advice is to stick with home-cooking until the loonie shows signs of decelerating. As far as stocks are concerned, focus on Canadian securities that are likely to benefit from our currency gains. One example is retailer Canadian Tire (CTR.A), which briefly touched $35 last month. Many of the products on its shelves are purchased with cheaper U.S. dollars and sold at higher Canadian dollars. Shoppers Drug Mart (SC) and Loblaw (L) are other companies that are worth a close look in these conditions. Check with your financial advisor.