July In Review: Taking a Look at the Canadian Dollar


By Rob Edel, CFA

Highlights This Month

Read this month’s commentary in PDF format.

The NWM Portfolio

Returns for the NWM Core Portfolio Fund were down 1.1% for the month of July.  We estimate the Fund portfolio has a U.S. dollar currency exposure of 36%.  Given the Canadian dollar was up 3.7% in July, simple math would indicate this negatively impacted the portfolio by approximately 1.3%.  The NWM Core Portfolio Fund is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships.  Actual client returns will vary depending on specific client situations and asset mixes.

The Canadian yield curve, again, experienced a parallel shift higher last month, with 2-year Canada’s increasing 0.21% and 10-year Canada’s +0.29%.  By contrast, yields in the U.S. were mainly unchanged.  For the month, the NWM Bond Fund was down 0.2% with our alternative credit managers delivering positive returns that helped offset the negative returns from our more rate sensitive strategies.  Overall, we saw a good result given the movement in interest rates during the month.

NWM High Yield Bond Fund returned -0.5% in July, negatively affected by its 33% USD currency exposure.  Currency aside, the general high yield market had another positive return month, with the Bank of America Merrill Lynch U.S. High Yield Index returned +1.2% in July.

Market technicals remained strong with strong inflows and low new issuance supply.  Fundamentally, high yield companies appear sound due to strong equity valuations, positive macro-economic indicators, and low projected default rates.  However, high yield credit spreads remain historically tight (currently 361bp spread over government yields versus a range of 300bps to 1000bps over the past 20 years, except for 2008/09 when it spiked to 2000bps).  The narrow spreads and low yields suggest very limited upside return and significantly greater risk.  The NWM High Yield Bond Fund managers remain defensive, with a 3.6% yield versus the index’s 5.5%, and a low and more liquid duration.

Global bond returns were weaker last month, with the NWM Global Bond Fund returning -2.7%.  This fund has an approximate 39% exposure to the U.S. dollar and an additional 58% non-Canadian dollar exposure, meaning it has only a 3% exposure to Canadian dollars.

The NWM mortgage pools continued to deliver consistent returns, with the NWM Primary Mortgage Fund and the NWM Balanced Mortgage Fund returning +0.3% and 0.5% respectively.  Current yields, which are what the funds would return if all mortgages presently in the fund were held to maturity and all interest and principal were repaid and are in no way a predictor of future performance, are 4.1% for the NWM Primary Mortgage Fund and 5.5% for the NWM Balanced Mortgage Fund.  The NWM Primary Mortgage Fund ended the month with cash of $23.0 million, or 13.6%.  The NWM Balanced Mortgage Fund ended the month with $43.4 million in cash or 8.7%.

The NWM Preferred Share Fund returned 1.7% for the month of July, matching the BMO Laddered Preferred Share Index ETF.  Credit spreads narrowed slightly during the month while 5-year Government of Canada bond yields rose providing a tailwind for low spread rate reset for preferred shares.  The market remains attractive; however, new issuance pricing has become slightly more expensive.  We believe that bank resets in the secondary market provide better pricing and have been actively focusing on the secondary market for rate resets with higher dividends to increase price stability and lower volatility.

Canadian equities were modestly weak in July, with S&P/TSX -0.1% (total return, including dividends).  The NWM Canadian Equity Income Fund returned -0.4%, with positive contributions from positions in the financials being more than offset by negative consumer discretionary returns.  The NWM Canadian Tactical High Income Fund gained 0.3%, despite the slight decline in the overall market.  The fund still maintains a low net equity exposure (current delta adjusted exposure is 42%).  No new positions were added in the NWM Canadian Equity Income Fund, while the NWM Canadian Tactical High Income Fund wrote new naked put positions on Genworth.

Foreign equities were weaker last month, with the NWM Global Equity Fund down 1.8% compared to a 0.5% decline in the MSCI All World Index and a 1.9% drop in the S&P 500 (all in Canadian dollar terms).  Like the market, all our external managers had negative returns last month, with Pier 21 Value Invest -2.6%, Edgepoint -2.0%, Lazard Global -1.5%, BMO Asia Growth & Income -1.4%, and Pier 21 Carnegie -1.3%.  Our new internal Europe Australasia & Far East (EAFE) quantitative investments returned -0.7%.

NWM U.S. Equity Income Fund increased 1.9% in U.S. dollar terms and the NWM U.S. Tactical High Income Fund increased 0.5% versus a 2.1% increase in the S&P 500 (all in U.S. dollar terms).  In the NWM U.S. Equity Income Fund, we initiated a position in Vulcan Materials and Du Pont, using the proceeds from partial sales of Boeing and LyondellBasell Industries.  As for the NWM U.S. Tactical High Income Fund, we were called away on our position in Hanesbrands.  The net equity exposure (delta) in the NWM U.S. Tactical High Income Fund is only 28%.

Real estate was weak in July with the NWM Real Estate Fund down 2.0% versus the iShares REIT Index -1.4%.

The NWM Alternative Strategies Fund was down 1.4% in July (these are estimates and can’t be confirmed until later in the month) with Winton -3.9%, Citadel -1.6%, Millenium -2.9%, and Brevan Howard -1.2%.  We are still in the process of redeeming from the Brevan Howard fund.  Again, a stronger Canadian dollar provided a headwind for these returns when translated back into Canadian dollars.  Of our other alternative managers, all have a positive performance with RP Debt Opportunities +0.7%, Polar North Pole Multi-Strategy +0.2%, and RBC Multi-Strategy Trust +1.0%.

Precious metals stocks were weaker last month with the NWM Precious Metals Fund -2.9% while gold bullion down 1.6% in Canadian dollar terms.

 

 July In Review

The big story for Canadian investors last month continues to be the rapid appreciation of the Canadian dollar.  After rallying nearly 4% in July, the loonie is up 9.6% since the beginning of May, a remarkable winning streak over such a short period of time.

According to the Commodity Futures Trading Commission, speculators shifted from being massively short the Canadian dollar in only May to being net long at levels not seen since early 2013.  As a result of the strong move in the Canadian dollar, any asset based in U.S. dollars had a tough go last month.

July was another great month for the S&P 500, Dow, and Nasdaq, with all three indexes up 2.1%, 2.7%, and 3.4% respectively, but were -1.9%, 1.3%, and -0.6% when translated into pricier Canadian dollar terms.  By comparison, even Canadian stocks managed to top these results, with the S&P/TSX Index basically unchanged at -0.1%.

So where does the dollar go from here?  Based on current market fundamentals, the International Monetary Fund (IMF) estimates Canada’s inflation-adjusted exchange rate is currently close to fair value.  Of course, the IMF calculations are very theoretical and the market moves more on sentiment, particularly in the short term.  In order to monitor sentiment, factors impacting the economy, oil, the housing market, and politics, will all be important over the coming months.

From an economic perspective, the recent strength of the Canadian economy more than justifies the strong move in the Canadian dollar.  Real gross domestic product (GDP) jumped 0.6% in May, with the economy up 4.6% over the past 12 months, its fastest growth rate since 2000.

Yes, this increase is exaggerated by favorable comparisons to last year due to the Fort McMurray wildfires, but forecasters are still predicting Q2 GDP growth should come in around 3.5% and 3% growth for 2017 in total versus estimates of around 2.0% only six months ago.  The IMF is a little more conservative in predicting 2.5% growth for Canada in 2017 versus their April forecast of only 1.9%, but this would still be the highest of all the G7 countries.

Manufacturing indices remain strong; with the unemployment rate of 6.3% in July falling to its lowest level since October 2008 and nearly 390,000 jobs created over the past 12 months, the most since 2007, the state of the Canadian economy would appear to justify the recent appreciation of our currency.

All is not as it appears, however.  Canadian wage growth remains weak and the participation rate continues to be stubbornly low.  While Statistics Canada’s Labour Force Survey (quoted above) shows strong growth in the job market, the Survey of Employment, Payrolls and Hours, which is based on payroll data supplied by CRA, is less rosy and suggest paid employment year to date has averaged only 11,000 new jobs a month, the lowest since the 2009 recession.  Which Statistics Canada survey is right is debatable, though we would tend to favor CRA’s hard numbers versus the information people have provided data collectors about their job status in the Labour Force Survey.

The strong Canadian dollar won’t help economic growth either.  The Bank of Canada estimates the recent gain in the dollar is equivalent to a 0.5% rise in interest rates and could trim GDP growth by 0.3%.  Interest rates themselves have already moved higher, with the Bank of Canada raising the bank rate 25 basis points last month to 0.75%, and signaling they are ready to do more.

Two-year government bond yields gapped up 0.2% in July and are up over 0.6% since the beginning of June, while 10-year bond yields were 0.3% higher last month and are up nearly 0.7% over the last two months.  It’s a double whammy for the Canadian economy.  Over the past 20 years, the Canadian economy has been one of the most volatile in the developed world, a trend likely to continue.

One of the largest contributors to the volatility of Canadian economic growth has been Canada’s reliance on the oil and gas sector.  The fall from over $100 a barrel in mid-2014 to under $40 a barrel for WTI crude oil in early 2016 took a toll on the Canadian energy industry and the province of Alberta in particular.  Western Canadian Select crude, which is more relevant for Canadian producers, actually fell to around $18 a barrel.  Prices have rebounded to about $50 a barrel for WTI and $40 for Western Canadian Select as of early August.

A recent poll conducted by the Wall Street Journal of 15 investment banks predicted WTI oil would average $51 a barrel in 2017 and $53 a barrel in 2018, both forecasts down $2 a barrel from a similar poll conducted in June.  Western Canada Select prices could see more of a rally given falling oil production in Venezuela.

Both Canada and Venezuela produce mainly heavy oil, which is the grade many U.S. Gulf Coast refiners are designed to handle.  The only problem with substituting oil from Venezuela with Western Canada Select is transporting it from Canada to the refiners on the Gulf Coast.  With most pipelines currently running at capacity, rail will likely be the only alternative in the short term.

Higher oil prices and increased exports would be good for the Canadian economy and the Canadian dollar.  While predicting the short term direction of oil has proven to be extremely difficult of late, a lack of investment in future production could result in lower supply growth in the longer term.  We believe the downside for oil is limited and risks are skewed to the upside.

If the oil sector could be a future source of strength for the Canadian economy, housing could be its Waterloo.  By any measure, the Canadian housing market is expensive.  Of even more concern is the debt Canadian consumers have taken on in order to participate.

A recent Globe and Mail article highlighted a study conducted by National Bank of Canada finding that it now takes Canadians nearly 40 months to save for a down payment on a “representative home” using a saving rate of 10%.  This is national.  For Vancouver and Toronto, it takes 127.5 and 105.6 months respectively.  BCA Research believes a down turn in spending due to high debt levels isn’t just a risk, but a highly probable event for the Canadian economy in the long term.

Real estate has become a big driver for the Canadian economy and is one of the reasons why Canada’s GDP growth rate is the highest in the G7.  According to Macquarie’s David Doyle, real estate fees alone (commissions, land transfer taxes, legal costs, and inspection fees) are estimated comprise nearly 2% of Canadian GDP.  Estimates for the impact on Canada’s GDP from a correction in home prices range from -0.2% to -0.5%, which is significant given the Bank of Canada is only forecasting GDP growth of 2.0% next year.  Timing is key, however, and the historical triggers for a housing correction are not present at the moment.

Interest rates are expected to remain low for the foreseeable future and the unemployment rate continues to decline.  Also, just because prices are high, doesn’t mean a correction is imminent.  House prices in Australia, New Zealand, Norway, Sweden, and the UK have also avoided a U.S. style crash while incurring similar price increases as Canada.

Many believe high prices are justified by high demand and constrained supply.  BCA Research, however, recently labeled tight supply being responsible for the increase in prices as a myth, showing Toronto and Vancouver as actually having low population densities compared to other cities with a similar price to income ratios.  Based on relative density, prices are 80%  overvalued in Toronto and 140% over valued in Vancouver.  Of course, this analysis assumes a reversion to the mean would be created by prices moving lower rather than density continuing to move higher.  Anyone looking at the Vancouver or Toronto skyline would attest to the fact higher density is winning this battle right now, and this is very positive for economic growth.

The housing market is probably the biggest risk for the Canadian economy.  Common sense tells us it has to correct sometime, we have just given up trying to predict when.  When and if it does happen, however, the impact on the Canadian economy and the Canadian dollar will be significant.  Even without a correction, we don’t see how Canadians could continue to borrow more money without wage growth accelerating.  Even a modest increase in interest rates is going to hurt.  It’s one of the reasons we don’t see interest rates moving significantly higher over the near term because it would sink the Canadian economy.

While the strength of the Canadian economy has been a significant contributor to the rise in the Canadian dollar, the biggest driver has actually been the overall weakness in the U.S. dollar.  Sure the loonie has rallied strongly against the greenback over the past couple months, but year to date, the U.S. dollar is down against most currencies.  The U.S. Dollar Index, which measures the value of the dollar relative to a basket of foreign currencies, has in fact fallen over 9% so far this year.

Measured against the Euro, the Canadian dollar is actually down over 4% this year.  While a weak U.S. dollar is not so great for foreign investors, it’s not such a bad thing if you are an American company.  A weaker dollar makes U.S. exports more competitive and U.S. companies with foreign revenue gain from a weaker currency when that revenue is translated back into U.S. dollars.  This is likely why U.S. equity markets have continued to move higher while foreign markets have begun to soften.

As of the end of 2016, S&P Dow Jones estimates 43% of the S&P 500 revenues came from outside of the U.S.  For the U.S. dollar to continue to weaken and the Canadian dollar strengthen, the U.S. economy and U.S. corporate earnings growth would need to wane as well.

According to Thomson Reuters, S&P 500 earnings are expected to increase 11% in Q2 after rising 15% in Q1, the first time since 2011 that the S&P 500 has managed two consecutive quarters of double digit growth.  Sales were also strong, gaining 5%, the second largest increase in over five years.

Fatter bottom lines have led to consistently higher equity prices.  The Dow Jones Industrial Average topped the 22,000 level in early August after hitting the 20,000 mark in January.  The Dow’s record closing level was its 32nd record of the year.

While the technology sector has led the market higher, it did underperform last year after the election and the recent move has been more of a catch-up rally.  No sector, in fact, looks to be forming a bubble, with the exception perhaps of the market as a whole.  Even then, equities look cheap compared to bond valuations.

There are some warning signs that the current economic cycle may be maturing.  Growth remains slow with the current expansion recording one of the weakest average growth rates on record.  It’s also long in the tooth;  at over eight years old it is now the third longest expansion in the Post-World War II era and the unemployment rate has been trending lower for 93 straight months, one short of the record set during the Clinton Administration.  With inflation remaining unusually weak and manufacturing activity, consumer confidence, and auto sales turning lower last month, there are some concerns that the U.S. economy could be beginning to show its age.

According to a recent survey of economists conducted by the Wall Street Journal and confirmed by Goldman Sachs, the odds of a recession have in fact increased.  At the margin, economic data has softened, but consumer sentiment is coming off of pretty high levels and most manufacturing indices’ continue to point towards expansion.  The odds of a recession have increased, but they are still only moderate at best.  Job growth remains vibrant, however, low inflation and the slow growth economy should give the Federal Reserve room to gradually move interest rates higher, but not enough to throw the economy into recession.  This “Goldilocks” environment should be positive for the U.S. dollar and thus relatively negative for the Canadian dollar.

Of course, Goldilocks never went to Washington, which remains a mess.  The Republican-controlled Senate finally conceded defeat on trying to reform health care and many are worried tax reform will be an even harder pass, considering President Trump’s approval rating continues to plummet with the White House in perpetual turmoil.

Chief of Staff Reince Priebus and White House Press Secretary Sean Spicer are gone, and the new White House Communications Director Anthony Scaramucci lasted only 11 days.  Given recent tweets from Trump, Attorney General Jeff Sessions could be next to leave.  Eyes are also on National Security Advisor General H.R. McMaster, who has appeared to clash with White House Chief Strategist Steve Bannon and Trump’s son-in-law and Senior White House Advisor Jared Kushner, who are also rumored to be feuding.  The New York Post recently compared the White House to the reality show Survivor, though likely way more entertaining.  For the market, and more specifically the U.S. dollar, the turmoil in Washington is bad, and one of the reasons why every global currency appears to be gaining on the greenback, despite relatively solid economic growth.

Global economic growth has picked up, with the Eurozone GDP growing an annualized 2.3% in Q2 and the European Central Bank (ECB) expecting 1.9% growth for all of 2017.  The unemployment rate in the Eurozone fell to 9.1% in June and centrist Emmanuel Macron’s victory in the French Presidential election provided renewed hope that the Euro will survive.  Inflation remains low, however, and economic growth could be starting to weaken with many manufacturing indexes recently starting to roll over.

From a political perspective, meaningful reform still remains a distant hope for the Eurozone.  The ECB will eventually have to start tightening, but it is certainly in no hurry.  The Euro has appreciated nearly 13% against the U.S. dollar year-to-date.  That’s enough.  Hedge funds and other speculative traders have been betting on both the Euro and the Canadian dollar to appreciate further against the U.S. dollar, but they are fickle investors and prone to quickly changing their affections.

So what does this all mean for the Canadian dollar?  While it is extremely hard to predict short term moves in currencies, we suspect the loonie will find it harder to continue moving higher from here.  Higher Oil prices could provide fuel for an additional move to the upside, but the housing market appears to be punching well above its weight class and an over-leveraged consumer could prove to be a headwind for future growth.  A stronger U.S. economy will be good for Canada, but we don’t see how Canada will be able to grow faster than the U.S. over the longer term.

As we mentioned last month, we like Canadian stocks, but we also think U.S. stocks are still very investable.  Politics are a risk for the U.S., but also for Canada.  The renegotiation of NAFTA and its impact on the Canadian economy is very hard to handicap, as is the recent white paper on potential changes to the taxation of private Canadian corporations.  We find it striking that Trump wants to lower taxes in order to help stimulate the U.S. economy while Canada is looking to raise taxes.  That can’t be good for the Canadian dollar can it?  The U.S. wanted a weaker currency, and that’s what it’s got, but the fundamentals don’t warrant a continued slide in the greenback or a continued increase in the loonie.

What did you think of July’s economic activity?  Let us know in the comments below.

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. NWM Fund returns are quoted net of fund-level fees and expenses but before NWM portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Please speak to your NWM advisor for advice based on your unique circumstances. NWM is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. This is not a sales solicitation. This investment is only available for sale to tax residents of Canada who are accredited investors. Please read the agreements and/or subscription documents for additional details and important disclosure information, including terms of redemption and limited liquidity.