Duck Hunt

Our golden Loonie is likely going a lot lower.

There is nothing more iconic to Canadian cottage country than the soundtrack of the loon. So much so, that instead of gracing our $1 dollar coin with our first prime minister (or president) like most countries, we chose a loon. Because of this, the Canadian dollar has been endearingly coined: “the Loonie”. Well, poor Loonie is in deep water now …you know, up the creek without a paddle…sinking fast…whichever you prefer. We have discussed this lofty Loonie for years in your Value commentaries but its front and center now. In our first quarter Value Fund report of 2013, we talked about a renaissance in America with the 3 main pillars being: low interest rates, on-shoring and a housing recovery. For a while, like others, the thought was this revival would help other nations struggling to pull themselves out of recession and sluggish growth. However, that view has changed. This revival is American made with a tag on products we haven’t seen for years that says…”Made in America”. Manufacturing and oil production occurring in America instead of Asia, the Middle East and especially Canada leaves America in an enviable position not seen in decades. Consequently, never (in my 25 year career) have the odds been so stacked against the Loonie.

Durable Damage from Strong Loonie – First, the strong Canadian dollar resulting from sustained high commodity prices decimated our manufacturing sector to the benefit of the commodity complex almost exclusively. A cruise on the 401 and down the QEW in southern Ontario drives this point home. Our auto sector is cooked. Plants are being closed and opened elsewhere. Even beyond auto, Caterpillar, Heinz, Kellogg’s, Campbell’s, Novartis, Sears and RIM have experienced shutdowns and layoffs. Admittedly, the last one was their own doing. The list is long and will continue to grow. The combination of a high dollar and high labour costs push Canada out of the running in global competiveness. Furthermore, America’s recession was so deep that there’s been labour cost deflation across many States. Combine this with technology and robotics and America has once again become a serious manufacturing competitor globally. Canada can have high labour costs or a strong dollar – not both. Meaning, jobs are going back to America.

High Energy Prices – High energy prices have resulted in new energy technologies and major oil and gas discoveries in the USA. This energy renaissance is leading America to becoming energy independent. Simply put, the USA will need less Canadian oil; as proved out in our last (not so) surprising trade deficit. Lower energy costs make American manufacturers even more competitive as margins expand from a declining expense curve, due to energy input either in manufacturing and/or transporting a product. In addition…energy jobs are going back to America. More production of oil and gas keeps prices down. The Canadian dollar is a petro currency and subject to being priced off oil. Going forward, it’s more likely energy prices are flat or down, than up. The economics of high prices is they bring on low prices through expansion, competition, capital investment etc. No need to go over basic economics here.

Interest Rates – We are seeing the commencement of a divergence, as rates rise in the USA while Canada talks of flat to declining rates to keep us limping along. This has a negative effect on the attractiveness of the Canadian dollar to foreign investors.

Investment Flows – For a decade, money poured into Canada. First, excitement over commodities led the rush. Then, when American and European financial sectors crashed and ours didn’t, we became a safe haven. This was folly of course as it was only high commodity prices that kept Canada from crashing. In 2008, the Loonie rapidly fell to 70 cents while CMHC bailed Canadian banks out of over $100 billion of risky mortgages. Oil fell to $35 and real estate prices declined precipitously. As rapidly as these fell, they recovered…commodities first, then a nanosecond later, the Loonie and real estate as China printed cash and poured it into construction. Consequently, 50% of China’s GDP became construction and clearly unsustainable. Real commodity demand and financial commodity demand for perceived inflation protection saved commodity producing nations from the brink. Mexico, Canada, Australia and Brazil were rescued while those economies consuming commodities suffered. Anyway this flow of funds is reversing itself. Investment returns are higher elsewhere, commodity excitement has waned, thus, global and Canadian investors will sell CAD denominated investments in favour of USD opportunities.

Real Estate & Debt – Canadian real estate is at all-time highs. Canadian’s debt is at all-time highs. Where does it go from here? Probably not up. If we can’t take on any more debt and we’re not gaining a whole lot of jobs, it’s doubtful the real estate and construction sector will be big contributors to Canadian GDP for a while. Real estate doesn’t have to crash to weaken our dollar…it just has to drift. It was a large contributor for a decade. The Americans have an accelerating construction sector and Canada a decelerating one – not a good position for a bird wanting to fly higher! Gravitational laws being what they are, deceleration causes a loss of altitude.

The result of this made in America renaissance is that ‘spin off’ benefits to Canada will be less than in past recoveries and growth will double-up for America. The fact is that GDP points will accrue to the USA to a much larger degree than many expect. It seems almost comical that whenever a strong economic number comes out of the USA the Canadian dollar has rallied. Anchoring biases and belief systems die slowly, I guess. With a large chasm below, the Loonie’s been gliding on hot air; unaware its wings are to be clipped.

How is Vertex Capitalizing? – Portfolio managers have the ability to hedge a portfolio’s exposure to foreign currencies when positions outside of Canada are held within a fund. Depending on the type of position and strategy there are reasons to eliminate or permit currency exposure. For example, fixed income portfolios investing in US yielding instruments tend to hedge currency exposure, so as to eliminate the risk of currency movements impacting the interest received. Conversely, a manager may choose not to hedge currency for equity holdings, in order to gain free exposure to an asset class and avoid the costs of hedging.

Vertex Value Fund and Vertex Managed Value Portfolio do not hedge currency exposure. With US holdings currently at about 75% in each fund that means the portfolios have a 75% position in USD. For example, if the cost of USD compared to CAD increases from 1.0 to 1.1 that represents 7.5% of profit to the fund.

In the Vertex Fund and Vertex Growth Fund, we have been strategically reducing the amount of currency hedges. Currently, there is about 25% exposure to USD in the Vertex Fund and about 50% exposure in the Vertex Growth Fund. Those numbers are actively shifting as we adapt to this change in condition from the past decade.

In the Vertex Enhanced Income Fund we maintain about 10% exposure to USD. This correlates similarly to the fund’s holdings in US equity. However, we will not exceed much more than this amount so as to protect interest payments from our US fixed income holdings.

The Vertex Arbitrage Fund utilizes a merger arbitrage strategy which generates its returns from narrow spreads over short time periods. Because of this, currency exposure is an unwanted variable in the equation. Therefore, we fully hedge currency in order to protect the predictability of its returns.

The Takeaway

Although the sinking Canadian dollar may affect your travel plans to the US or cross-border shopping habits, it can have a positive effect on your investment portfolio. If history is any indication, the devaluation has a long way to go to return to any long term average.

cad-usd USD/CAD Historical Chart

#untilnexttime

For information on this update or the funds we offer, please contact a regional VP of sales:

Noel Dattrino
(Western Canada)
604.408.5660

James Wilson
(GTA & Western Ontario, Maritime Canada)
519.902.7780

Michael Lindblad
(GTA & Eastern Ontario)
416.200.4457

Janine Breck
(Nationwide Inside Sales)
866.681.5787 x122 or 604.408.5663