The falling US dollar

Check out the travel section of any American newspaper these days and you will almost certainly find at least one story bemoaning the high cost of visiting Europe this summer. US travel agents are crying the blues and popular European resorts are offering special deals in peak season in an attempt to offset the effect of the sagging American greenback on tourism.

Interestingly, if you turn to the business pages you’ll hardly find a mention of the renewed decline in the value of the US dollar on world markets or the impact that is having on heightened inflation concerns in that country. There’s plenty of news about another Dow record high and on tightening restrictions on Chinese imports, but no one except the tour operators seems to be fretting much about the currency. Strange!

For the tourism industry, the psychological breakthrough came a few weeks ago when the British pound moved through the $2 level against the greenback. Americans don’t seem to pay a lot of attention to the exchange rate against the euro, perhaps because they still have not come to grips with that strange currency. But the pound sterling has been around a long time and seasoned travellers watch it closely. A $2 pound makes those quick London getaways a lot pricier.

Actually, the difference from the start of the year isn’t all that much in percentage terms. At the time of writing, the US dollar was down 1.4 per cent against sterling and about 2 per cent against the euro in 2007. But it seems to be enough to persuade more Americans to vacation at home. (Conversely, the Canadian dollar has risen in value against both currencies since the start of the year, making European holidays cheaper for us.)

All this is to say that Americans have lost focus when it comes to their deteriorating currency. This is probably because the policy-makers in Washington are for the most part staying quiet about the situation. You don’t hear any alarm bells being rung at the White House or the US Treasury. Why? Because a cheaper greenback reduces the cost of US exports to foreign buyers, thereby making made-in-America products less expensive in international markets. More exports will help to reduce the chronic US trade deficit, as will greater restrictions on Chinese imports.

In Canada, we have of course been experiencing the flip side of that coin since early 2003 when our loonie was languishing at close to US60c. The rapid rise of our dollar in the years since has hit the bottom line of almost every Canadian company – just check out their annual reports to see by how much – and has forced us to sharpen our pencils and be more competitive. That’s not a bad thing, in principle, but the process can be painful.

Earlier this year, it seemed that the loonie’s run was over and that it was about to settle into a trading range between US82c and US85c. But in the past month it has shot up again, partly as a result of Washington’s apparent willingness to accept further devaluation of the greenback, partly because of a strengthening of oil prices, partly because of our economic and fiscal stability, and partly due to increasing expectation that interest rates will rise in this country before year-end.

Currently, our rates are significantly lower than those in the US, which is a reversal of historic patterns. If the gap begins to close, as many now expect, our dollar will become even more attractive to global hot money. Some of our top economists now believe that is likely to happen; the Royal Bank said last month that it expects the Bank of Canada to raise its overnight rate by a full percentage point between now and this time next year. The US Federal Reserve Board is also expected to tighten because of growing inflation concerns (which are of course exacerbated by a declining greenback, which will make imports more expensive), but not by that much.

What conclusions should we draw from this as investors? There now appears to be a better-than-average possibility that the loonie will trend higher over the next few months. This would have a negative impact on returns from US stocks. But we need to keep things in perspective. Even if our dollar should hit parity, that represents an increase of about 7.5 per cent from current levels. That’s a long way from the 45 per cent increase we have experienced since 2003. Yes, it’s a consideration but it is not in itself enough to rule out US securities from your portfolio.

Some people have asked me about the desirability of diversifying into euro-based companies to reduce the currency risk and that is certainly worth considering. The loonie is up against the euro since the start of the year, but only by 2.3 per cent compared to a 5.3 per cent appreciation against the greenback in that period.

Whichever direction you choose, do not let the strength of the Canadian dollar deter you from international portfolio diversification. As I have said on many occasions, our market is limited in breadth and very tightly focused on two sectors: resources and financials. We’ve done very well by staying at home for the past few years but that won’t always be the case.

In fact, strong though the Canadian market has been, if you did not have some foreign exposure last year you missed out. According to data compiled by Franklin Templeton, Canadian large-cap stocks gained 17.3 per cent in 2006 while small-caps were ahead 16.6 per cent. By comparison, global equities were up 21 per cent on average. BRIC equities (Brazil, Russia, India, and China) were the strongest performing category last year, gaining 56 per cent. It’s also worth noting that since the current bull market began in late 2002, Canadian stocks have never topped the performance list in a calendar year. Sure, we have done well but others have done better.

So don’t back away from global diversification. As long as you choose international securities that significantly outperform (which is what I always look for), any currency losses will be more than offset by your market profits.