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Canadian Underperformance

01/22/2014

Last Thursday, I delivered the keynote address for the Alta Corp Capital Institutional Investor Conference at the Shangri-La hotel in Toronto, Ontario. With many CEOs from Canada’s oil, gas, mining, agriculture, and industrial sectors present, a request was made for me to specifically outline the underperformance for Canadian assets relative to the U.S. over the past 12 months.

I think it is important to understand—not only for those in attendance but also for all investors—what currently ails Canada and other commodity-intensive economies. The Canadian dollar has fallen 9.5% since the beginning of 2013, while another commodity-reliant economy Australia has witnessed its currency decline slightly more than 15%.

For me the correlation is simple: the challenges of the emerging markets. Contracting external demand for both Canadian and Australian resources from emerging markets is evidence that investors must continue to monitor emerging market assets because of the impact on other global assets beyond their respective borders. Very few economies beyond the United States can withstand an emerging market demand slowdown.

However, as I told the audience in Toronto, the ultimate question becomes, “Do you believe the demand contraction, and resulting deflationary pressure, is transitory or long lasting?” I presented evidence to support my expectation that the weakening should be viewed as transitory.

While emerging market headwinds provide the biggest challenge for Canadian assets, there also exists an odd condition in which Canada is being punished for being “first to recover” while the U.S., Japan, and Europe are being rewarded for being “late to recover”.

  • Canada was the first major economy able to lift interest rates post 2008. During 2010 the Bank of Canada raised its benchmark interest rate 75 basis points (Figure 1) while the U.S. embarked upon various rounds of further quantitative easing.
  • Canada experienced a rebound in home prices much faster than the U.S. In fact Figure 2 highlights the June 2009 to June 2010 dramatic rebound while U.S. home prices still declined.

So, yes, the Canadian dollar may decline further, possibly to the 1.13-1.15 range from its current 1.10 in the near term. CPI is trending below 1% year on year, raw material prices continue to fall, and investors contemplate an actual Bank of Canada rate cut. However, I am suspicious those conditions will persist. Any reversal will be enough to stabilize the decline of assets within Canadian capital markets even without a substantial tailwind from the emerging markets.

Apparently, the world’s second largest mining company Goldcorp feels similar confidence. If it wasn’t confident in a raw material turnaround, would it have embarked upon a $2.4 billion (U.S.) unsolicited bid for Osisko Mining Corp.? Additionally, shares of agriculture equity companies such as Saskatoon’s Potash (Figure 3) have been attracting early 2014 interest from rather depressed levels. There seemed to be much more confidence and optimism at the Shangri-La hotel than is currently being exhibited by Canadian capital markets. As a U.S. citizen, I sure hope we quickly embrace the exportation of liquefied natural gas (LNG) because western Canada is clearly positioned to grow that business based on the intentions of those energy CEOs in attendance.

So far in 2014, emerging market underperformance seems to be holding back global risk assets from further appreciation. However, I suspect emerging market underperformance can only do that for so long to Canadian risk assets. My time in Canada last Thursday only strengthened that expectation.

Figure 1 Bank of Canada Lending Rate

Source: Bloomberg

Figure 2 Canadian Home Prices, 2008 to Present

Source: Bloomberg

Figure 3 Potash Corp. (POT), Prior 52 Weeks

Source: Bloomberg

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