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The TSX sectors most likely to gain and lose from the cratering loonie

Identifying the domestic equity sectors with the most to gain and the most to lose from the cratering Canadian dollar is not an easy task. The last time the loonie experienced a sustained period of weakness was 20 years ago and the economic environment was vastly different from now in a number of ways.

We'll start with the math because it doesn't lie. But, as the astoundingly angry people in the comments section are fond of pointing out, statistical analysis can only suggest a cause-and-effect relationship and often misleads.

In the end, a combination of correlation-related and subjective analysis based on the last two decades of market data suggests Canadian auto and capital goods stocks have the most to gain from a weakening Canadian dollar. Materials and energy stocks are the most at risk.

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It makes perfect sense that auto stocks climb as the loonie falls. Magna International, which dominates the S&P/TSX Automobiles and Components Industry Group Index, generates almost half of its revenue from outside Canada.

Even that number understates the sensitivity of the company to a weak domestic currency. Magna's major domestic customers are Canadian arms of the big three automakers who ship a large portion of their goods to the United States. When the loonie falls, the major foreign auto companies find it cheaper to increase production in Canada because wages are paid in a declining loonie (relative to the U.S. dollar). The increased activity results in stronger domestic demand for Magna's output.

The same logic holds for domestic capital goods stocks. Companies like Bombardier and SNC-Lavalin, although they can't seem to get out of their own way lately, will become steadily more competitive versus global rivals as the Canadian dollar falls.

The S&P/TSX Materials Index and the S&P/TSX Energy Index both have extremely high correlations to the Canadian dollar-U.S. dollar exchange rate at 0.83 and 0.77, respectively, since 1991 (a reading of 1.0 means perfect correlation).

The oversimplified answer to why this is the case is that commodities are priced in U.S. dollars. When the dollar rises, all things being equal, commodity prices fall.

In actual fact the relationship is far more complicated and the subject of debate among strategists. In general terms, conventional wisdom is that since the technology bubble, a weak U.S. dollar and declining U.S. interest rates funnelled global investment to the emerging markets. The higher levels of emerging markets investment boosted economic activity in the developing world, which in turn resulted in high demand for resources and rising commodity prices.

Regardless of the cause, emerging markets growth slowed in 2013 – notably in the non-China members of the BRIC nations – and the U.S. dollar strengthened. A shift to greater growth in developed economies suggests market leadership will move away from materials companies.

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Click here to see an infographic on long-term sector performance.

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