Get used to a high loonie, they said. Hedge your portfolio, they said.
Investors who took that advice and insulated themselves against a persistently strong Canadian dollar must now contend with the opposite problem.
The loonie’s steep decline over the past several months has forced Canadian investors to once again rethink their approach to currency risk.
“We’re hearing rumblings from portfolio managers who are starting to unwind some of their hedges because they’re starting to eat into their returns,” said C.J. Gavsie, head of foreign exchange products at BMO Nesbitt Burns.
The currency’s abrupt slide to a four-year low, combined with the expectation for further weakness through this year, has turned currency hedging into a liability.
For many years, investors largely benefited from the exchange rate. Between 1976 and 2002, the Canadian dollar steadily fell from above parity to a low of 61.79 cents (U.S.).
Over that time, Canadians holding securities denominated in U.S. dollars received a bonus once those investments were converted back into ever shrinking Canadian dollars. The relationship between the currencies held for so long that many investors felt there was little risk to having U.S. dollar exposure.
That changed in 2002, when the Canadian dollar began its long ascent back toward parity. Over the next five years, Canada’s strength in resources bolstered the currency as China’s appetite for raw materials began to expand at a furious rate.
The loonie’s appreciation during that period eroded returns on cross-border holdings. “All of a sudden, you had people looking at their portfolio returns, which were beating eaten away by [foreign exchange] movement,” said Shaun Osborne, chief currency strategist at TD Securities. “That was a wake-up call not just for retail investors, but for a lot of portfolio managers as well, who until that point were not terribly bothered by [foreign exchange].”
Hedging came into favour as the necessary antidote. The big fund companies offered products designed to offset the Canadian dollar’s lofty profile. Investors could maintain their U.S. holdings while neutralizing the corrosive effect of loonie appreciation through the use of derivatives.
For a while, the strategy worked all right. While the Canadian dollar’s strength was interrupted first by the financial crisis, then by the European sovereign debt crisis, it nonetheless orbited around parity with the greenback. Canada’s natural abundances were supplemented by an interest rate differential against the United States, which drew foreign investors into Canada in search of returns.
But over the past year the case for hedging has eroded. Emerging market growth faltered, cutting global demand for commodities and for Canadian dollars.
In addition, the U.S. economy finally began to show signs of a sustainable economic recovery. The gap between yields on U.S. and Canadian benchmark bonds has now fallen from about 70 or 75 basis points at the start of 2013 to about 10 to 15 bps. The diminishing spread gives foreign investors less reason to buy loonies.
That trend is not likely to change. The U.S. Federal Reserve’s slow withdrawal of monetary stimulus should continue to lift U.S. yields. Meanwhile, a horrendous jobs report released Friday, which showed that Canadian employment growth in 2013 was the slowest since the recession, raised the possibility of a rate cut by the Bank of Canada.
On that news, the dollar dipped to 91.36 cents on Friday morning, its lowest level since September 2009, when the currency was still emerging from its crisis-induced trough.
The loonie, having now dropped by 11 per cent since September 2012, has not been kind to those investors who have maintained U.S. currency hedges. They may, however, find consolation in the astronomical capital gains generated by U.S. stocks in general over that same period.
So far this year, the S&P 500 is down, albeit minimally. An unhedged investment in the index, however, would be made positive by the loonie’s depreciation.
“A weaker Canadian dollar is actually juicing up investment returns quite nicely for Canadian-based investors,” Mr. Osborne said. Annualize that trend, and the currency effect can have a big influence over returns.
Currency risk management must be regularly re-evaluated, Mr. Osborne cautioned. But most forecasts predict further weakness in the loonie through this year, some of them expecting another 5 or 6 cents of downside. “Our advice to clients and investors generally over the last couple of years is to buy U.S.-dollar-denominated assets on an unhedged basis.”