By Dylan Smith

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Why the Canadian dollar could be stuck in a 'low-for-long funk' Back to video

The rubber is meeting the road on the interest rate divergence theme. The Bank of Canada cut its rate by a quarter-point on Wednesday and the European Central Bank followed suit on Thursday. Meanwhile, recent Fedspeak has been stodgily hawkish. When the United States economy diverges from its G7 peers, the natural place to look for investment opportunities is north.

Canada’s economy is so tightly linked to the U.S. (via trade, capital flows and labour markets) that any divergence in growth, inflation or interest rates causes assets in Canada to reprice to help the economy adjust.

We’re bullish on Government of Canada bonds, but we think the loonie is stuck in a low-for-long bind. In equities, you want to be biased toward the industries where a weaker currency will boost margins: favour the manufacturing, transport and media industries; avoid consumer staple goods, retailers and banks.

We start our analysis by looking at the fair value of the Canadian dollar, which bears most of the brunt of the adjustment to keep the economic relationship between the U.S. and Canada in equilibrium.

Our model of U.S. dollar-Canadian dollar fair value is based on financial variables with three main drivers: interest rate differentials, inflation and commodity prices. The fair value for the loonie is currently below 80 cents U.S. That’s well under the historical norm. Despite that, the loonie is currently trading at less than that fair value estimate.

To understand the underlying dynamics, we attributed the changes in fair value since the start of 2020 to the different drivers. Recently, wider spreads against U.S. rates (capturing the diverging growth and monetary policy outlooks) have been dragging fair value down, but commodity prices (gold and key industrial metals) are working against that to hold it up. That tells us that there may be some upside to the loonie, but it’s limited, and we wouldn’t be surprised if its fair value fell down to current trading levels rather than vice versa.

That said, there is also limited downside in the loonie: it’s stuck in a low-for-long funk. Investors have priced in the rate divergence and inflation is low and stabilizing. That downside protection is actually very important for the Bank of Canada, because it means that interest rate cuts won’t trigger a big fall in the currency that, in turn, might destabilize prices.

So, the loonie trading a little under fair value is not a buy, but it is an important catalyst for rate cuts. That makes Canadian bonds attractive at current prices for U.S. investors, even unhedged ones.

The natural question that comes next is how a low-for-long loonie will affect Canadian companies, many of which buy inputs and sell products in the U.S.

To answer that question, we looked at the correlation between the annual change in profit margins in the different S&P/TSX composite index industry groups and movements in the U.S. dollar-Canadian dollar exchange rate since 2006. The results are enlightening and, in some cases, run against conventional wisdom.

Overall, the relationship’s fairly weak, ranging from a correlation of a two-percentage-point margin improvement for the biggest winner to a 3.6-percentage-point deterioration for the biggest loser, assuming a 10 per cent weaker loonie.

Many industries have virtually no correlation to the Canadian dollar at all, which makes the industry groups in the middle good places to hide for investors who want to limit Canadian dollar exposure.

In some cases (domestically focused services industries), companies are too local to be affected by the exchange rate. But in others, it’s because of the almost perfect offset in exposures. The energy industry, for example, gets margin stability from the fact that commodity prices and the loonie are highly correlated, so gains in one are offset by losses in the other, on average.

Additionally, for industries that both buy inputs and sell end products in the U.S. or that have strong enough pricing power to pass exchange rate losses onto consumers, fluctuations in the value of the Canadian dollar are a wash.

In a weak loonie environment, that leaves just a handful of winners and losers.

In the winners column are industries with a good export profile: auto manufacturers, transportation companies (continental transport firms price in U.S. dollars, and this sector has tourism export exposure, too), and the entertainment industry (which exports production and location services — Vancouver and Toronto have played a host of U.S. cities on the silver screen, but never themselves). Canadian telecoms, which have strong pricing power and very high interest burdens, also tend to benefit when Canadian rates fall (alongside the loonie).

In the losers column are major importers that do see some margin squeeze when the currency depreciates (food, beverages and tobacco, consumer staples, materials, and capital goods). These are the stocks to stay away from, all else equal.

The lower interest rate and weaker economy that usually accompany a weaker loonie also tend to hurt margins at banks (lower net interest income and weaker loan performance) and erode profitability (and solvency ratios) at insurance companies.

Bottom line: There are good trades beyond the bond market to help make portfolios robust to the challenge of a global interest rate divergence. In Canada, different sections of the S&P/TSX composite have different exposures to a low-for-long loonie. Other factors matter, but this macro theme suggests favouring media and manufacturing and ditching banks and consumer staples.

Dylan Smith is a senior economist at independent research firm Rosenberg Research & Associates Inc., founded by David Rosenberg. To receive more of David Rosenberg’s insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.