The story of the Canadian dollar

Over the years, the Canadian dollar has seen some considerable ebbs and flows. In 1864, the greenback traded at $2.78, an all-time low for the US currency. In 2002, by contrast, the "Loonie" traded as low as 62 cents.

What's recently happened to the Canada dollar is a once-in-a-decade event. Much of the impact of foreign investments has been muted to the extraordinary increases in the Canadian dollar.

Why has the Canadian dollar appreciated?

The rise in the Canadian dollar is a caused by a number of factors:

• the relative weakness of the US dollar as of a result of spiraling debt, both public and private
• Canadian resources - oil, gold, base metals, even wheat are at near record highs
• demand is soaring in Asia
• our debt position is good, and improving
• massive amounts of buyouts, almost $1 trillion of Canadian companies.

All in all a perfect storm of confidence in the Loonie.

But it's the drive for commodities that has the most impact on our currency. We supply oil to the world, and they have to buy it in Canadian dollars. As the price of oil goes up, so does the need for Canadian dollars.

What could upset the apple cart?

We have to recognize that the Canadian currency appreciation is tied to the price of oil and the acquisition of Canadian companies by foreign entities. The price of oil is in turn dependent on global supply and global concerns around Iraq and Iran. The appreciating Canadian dollar also makes it more expensive to do business in Canada, so merger and acquisition activity could be lower for Canadian companies. The federal government is reviewing changes to legislation governing acquisitions by foreign entities.

The supply side of oil

From a recent article in Barron's:

"Over the past year, Saudi Arabia has had to cut its production by almost a million barrels a day to accommodate the impact of non-OPEC supply growth and because of weaker-than-expected world oil-demand growth. It wasn't that they were depriving people of barrels, but OPEC had less demand for their oil - and the bulk of the cuts occurred in Saudi Arabian production. The Saudis are about to bring on a big field in the fourth quarter, Khursaniyah, that's an 800,000-barrel-a-day project, and they are looking at demand numbers that are being revised downward. World oil-demand growth hasn't been at nearly the pace people thought it would be.

What about the demand from China and India and the notion that supplies have peaked? The data doesn't show it. If you look at the International Energy Agency industry data and you do an apples-to-apples comparison of non-OPEC supplies, supplies from all of the countries outside of OPEC, you will see growth rates are running substantially higher than people believe to be the case. Growth in non-OPEC supply this year looks like it will be about 1.3 million barrels a day, and that number is about twice what people believed would be the case. And the Saudis clearly have the barrels available. They are bringing on new fields. Khursaniyah is coming on in the fourth quarter, Nuayyim next year and Shaybah next year and Khurais in 2009. These are fairly big additions."

Why would a US dollar appreciate?

In the currency market, everything is cyclical. A strong currency will eventually become a weaker one as it hampers growth, while a weaker one will eventually become a stronger one since it spurs growth.

What this means is that unless the US goes out of business, the dollar will eventually turn around. The ensuing chain of inter-market events should cause commodities and emerging markets to pull back.

A bubble is currently forming in emerging and commodities markets, because of a dropping US interest rate and thereby its currency. We find it hard to bet against the US; after all they control almost half of the world's wealth. The US didn't become the world's wealthiest nation by accident. It will rebound, it always does. The mortgage crisis, and the resulting economic slowdown, will shrink the trade deficit.

We think that what we are seeing now in the US dollar is similar to what happened with Canada in the 1990s. Canada had too much debt. And deficits just got too large. Canada was essentially forced into a devaluation scenario to pull out of this nosedive. The US is attempting the same thing now. Just as Canada emerged from its debt problems, by dropping its currency and increasing its trade, so will the US. A lower US debt, with higher export trade and less foreign involvement could make for an attractive currency.

Senior bank analysts have indicated that they believe the Canadian dollar will fall. As well, Bank of Canada Governor David Dodge remarked that "speculative gains in the currency would cause monetary policy to be more simulative than it otherwise would have been" - in other words, we need lower interest rates.

What's an investor to do?

The key to every extreme is to try and remain rational with regard to investment decisions. Canada is doing very well; however, it is very small in relation to other world markets. If you want a diversified portfolio, developing a globally focused portfolio, although it currently seems the hardest thing to do, is actually the most prudent. In fact, your emotions may be your greatest investment tools - the investment you want to move out of, may be the best one to be adding to. Rather than reduce your exposure to global portfolios, now may be a good time to add to them with a higher Canadian dollar.

Diversifying across borders, sectors and company size is a brilliant strategy. However, do not try to predict which geographical area, size or type of company is going to be on top in a given year. In fact, of 10 major global market indices, each one has put in at least one great year of performance between 1985 and 2005 and has suffered a bottom finish as well. The lesson is simple. Spreading your investments more broadly will increase your performance over time but more importantly, will reduce risk. You need to have the patience and willingness to stick to your discipline.