Canada Rally May Get a Currency Hangover

The TSE 300 has been strong, but any tech slip in the U.S. is a threat.
Author:
Publish date:

Since the most direct route for Santa Claus to reach the U.S. will take him over Canada, he might as well look down and take a look at a few investment opportunities. Whatever they are, they're sure to beat the in-flight movie.

The principal Canadian equity index, the

Toronto Stock Exchange 300

, or TSE 300, has a very different composition than the

S&P 500

; the index is roughly one-third primary resource production and distribution-related. But despite the relatively strong market for resource-related stocks, the TSE 300 may be vulnerable to any dropoff in U.S. tech stocks.

Given its apparent "old economy" orientation -- there is no specific group designated as "computers and technology" -- it's surprising how well the TSE 300 has done relative to the S&P 500 during 1999. Even more surprising is when this outperformance occurred (since roughly the same mid-October point that marked the Nasdaq's stupendous rally).

Hot Year up North
Canada's benchmark index has outperformed the S&P 500 this year

Source: Bloomberg

The pattern becomes even more puzzling when we break out the relative performances of the 14 groups (see chart below). Since Oct. 15, 1999, the hottest groups on the TSE have been the

Utilities

and

Industrial Products

, two groups that have been relatively weak in the U.S. The question becomes, then, why have the apparently prosaic stocks of Canada contributed to the outperformance of the TSE against the S&P 500 in this period?

Industrial Strength
The TSE's old-line sectors seem strongest this year

Source: Bloomberg

One part of the question is easily answered, and belies a standard classification scheme.

Nortel Networks

(NT)

, a leading telecommunications stock, is in the Industrial Production group, where it accounts for 51.445% of the 25-stock subindex's weight. The

Utilities

subindex is dominated even more by

BCE Inc.

(BCE) - Get Report

, a mobile telecommunications services firm; this single stock accounts for 73.058% of the 21-stock subindex's weight. The two stocks together account for 25.909% of the TSE 300's market capitalization; the two largest stocks in the S&P 500,

Microsoft

(MSFT) - Get Report

and

General Electric

(GE) - Get Report

, account for only 9.116% of market capitalization.

A second part of the question is answered by the Canadian dollar, or CAD, exchange rate. The CAD weakened steadily between December 1991, the time of the

Fed's

most aggressive rate cutting, and August 1998, just prior to the first of three U.S. rate cuts in the midst of the global financial crisis. The CAD/USD exchange rate moved to 1.567 from 1.135 during that period, a 38% drop in value. While this may have pleased Canadian exporters, especially oil exporters whose products were priced in U.S. dollars, it imposed a terrible penalty on foreign investors exposed to a continuously declining currency.

Moreover, the Canadian economic cycle was lagging that of the U.S. This is not surprising given the weakness in global commodity prices; nearly 35% of Canada's export revenue is resource-linked. The

Bank of Canada

was trying to avoid matching American rate increases, and that maintained pressure on the Canadian dollar as returns on Canadian paper remained below those of the U.S. During July 1999, yields on 3-month Canadian dollar deposits in the eurodollar market were yielding 175 basis points over 3-month eurodollars; this gap has since closed to a still-high 106 basis points.

Once U.S. rates started to move higher in mid-October 1998, the Canadian dollar stabilized and began to firm. Periods of rising U.S. interest rates, such as 1987 to 1991, coincide with periods of Canadian dollar strength; the Bank of Canada is forced to maintain higher interest rates than it desires in order to stem capital outflow and inflationary pressures.

Exchange Rate Blues
A strong equity market hasn't translated into a strong currency

Source: Bloomberg

The present confluence of trends -- stronger global economy, a revival of metals and energy prices, and higher interest rates -- suggests a forthcoming period of outperformance by Canadian financial assets, especially for U.S. investors, with much of the gain deriving simply from CAD appreciation.

Given the weight of Nortel and BCE in the TSE 300, we need to apply the

Dirty Harry

test of investing: How lucky do we feel? A downturn in tech stocks in the U.S. will have a disproportionate impact on the TSE 300.

We can counter this risk either by avoiding the two high-tech highfliers and concentrating our investments in Canadian value stocks, or by simply exposing ourselves to Canada via Canadian dollar futures.

Howard L. Simons is a professor of finance at the Illinois Institute of Technology, a trading consultant and the author of The Dynamic Option Selection System (John Wiley & Sons, 1999). At time of publication, Simons held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Simons appreciates your feedback at

commentarymail@thestreet.com.