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Time For Foreign Currency Exposure?

It has been a few years since Canadians have seen any need for currency diversification. With a soaring Canadian dollar for a period of roughly 4 ½ years-- the most respectable, speculative currency in the world, as we have called it -- foreign investment returns were penalized once translated back into the home currency over this period. By all counts, however, that era now seems to be over. Since its peak, by year-end 2006 the Canadian dollar had already fallen 6.4% against the US dollar and 12.1% against the euro (based on noon rates). A new era may have begun -- a period where foreign investments denominated in other currencies will supplement portfolio returns.

Before we tackle this topic to further present our case, allow us to make two important points. Canadians tend to have a narrowed vision when it comes to global currency movements. They focus almost singly upon one currency exchange rate -- the Canadian (CAD) versus US dollar (USD). That may be understandable given that the US is Canada's largest trade partner and right next door. Yet, investors often look no farther abroad. That is a mistake.

The world of currencies and financial assets, of course, is much bigger than may revolve around the Canadian/US dollar exchange rate. And, often, the heavy focus on the CAD gyrations against the USD hides the reality of financial developments and investment opportunities in the rest of the world. While currency trends can be confusing over the shorter-term, they do tend to move in broad, longer-term patterns. The results can be surprising.

Case in point: Between the start of 2005 and end-2006, the CAD dollar rose 5.4% against the USD, the euro fell slightly (1.2%) against the USD and therefore the CAD rose 6.7% against the euro. These movements seem intuitive and rather quiescent over these two years. However, there were some very large swings during that period. Next, consider the 3 year period before that -- the beginning of 2002 to the end of 2004. The results were very different.

During that period the Canadian dollar soared against the US dollar -- up a whopping 33.3%. For Canadians, investments in the US were hugely penalized by this rise in CAD. However, there is a surprise. The Canadian dollar actually declined against the euro during that same period. The CAD fell 11.4% against the European heavy-weight. What that meant was that while US investment returns were being hammered by the slumping USD, investments in the eurozone were buoyed by a weakening CAD. This result was not all that intuitive.

Sadly, because of the slumping USD in past years, many Canadian investors have therefore been running from any foreign investment (not just USbased investments) and have overlooked other attractive opportunities around the world. The same effect can be seen in professionally-run mutual funds and other portfolios. Foreign investments are at near lows ...even in funds that designate themselves as offering foreign exposure. These funds have been scrambling as the CAD has weakened this year, as already outlined.

The conclusion: The CAD/USD rate isn't the "be all and end all" of foreign investing.

The second point we want to make hits into the longrunning argument about whether investors should be exposed to foreign currency movements when venturing abroad in their portfolio investments. Here is the age-old question: Should portfolios be hedged or not? It's the wrong question, we think. The more valuable answer is to another question: When should foreign currencies be hedged and when should they not?

Well, say some, currency movements can't be predicted therefore why expose investors to the vagaries of foreign currency markets? This is a cop-out in our view and doesn't match up with reality and facts. In the world of investments today, where geo-politics and globalization are the most determinative forces upon any country's financial markets, does it make sense to exclude currencies from the world of investment policy? To simply follow a policy of hedging all foreign currency exposure, through thick and thin, is therefore really an abdication of the professional services and advice that portfolio managers should bring to their clients.

Currency trends do move in definable patterns, and moreover, tend to bounce between periods of extreme over- and under-valuation. That can have a predictable influence upon foreign investment returns.

Let's look at some history that shows that currency contributions to investment returns do tend to work over alternating and longer-term periods. The statistics shown in the table on the bottom of the front page applies to the CAD movement against the USD and its affects upon international equity returns. We used the Barra/MSCI EAFE equity market returns for this sample. (EAFE stands for Europe, Australia and the Far East.) We then categorized the related currency trend according to the nearest year end.

Observable are broad periods of time where the CAD has moved in a persistent trend over a number of years -- i.e. ... the 1975-1985 period some 11 years long. We observe four distinct periods over the past 3 decades where the CAD movement against the US either added or detracted from foreign equity returns for long periods of consecutive years. Moreover, these periods then alternate. Roughly, on average, the currency impact on returns (add or detract) ranged between 3% to 5% per annum over these four distinct periods.

The conclusion? Yes, shorter-term currency movement are difficult to predict. Indeed, our experience in analyzing currency markets for over 25 years certainly supports that view. Yet, at the same time, it is also true that over time, currencies do move in line with explainable, causal factors, tending to make substantial moves before changing direction.

In a future issue of The Global Spin, we'll provide a brief outline of our currency methodologies.

Conclusion: Now's Not the Time to Hedge

What do our models indicate will be the next big directional move in currency markets? For one, the Canadian dollar remains overvalued against the USD. It can still fall much further against the USD. It would only follow that the next period (à la the 4 periods that we profiled since 1974) will be one that contributes to foreign equity returns.

As for the USD, things here get interesting. Indeed, the USD needs to fall further if world savings imbalances are ever to smooth out. Yet, geopolitics have entered the equation, temporarily suspending the proper functioning of free currency markets. On the one side, China is clearly managing its currency as a geopolitical lever. One consequence of this is that Europe (the Eurozone), on the other side, is unfairly taking the pressure for America's enormous current account and trade deficits. They will now join the US in pressuring Asian countries (particularly China) to get off their dollar-linked currency policies. Thailand's recent financial market bumps are a symptom of these developing rifts, and may be seen as an early tremor of coming shifts.

All the while that the US and Europe may be focused upon breaking the dollar-pegs in Asia, another contingent will be buying the euro (and also the yen, though less so) at every opportunity. Those are the oil-exporting countries, specifically the six members of the Gulf Cooperation Council and Russia, to name two prominent such entities. They are accruing dollars (plus $450 billion per annum according to the Bank of International Settlements) at a greater rate even than all of Asia. By all indications, they wish to diversify away from their high exposure to the USD.

We draw several relevant conclusions for our longerterm investment policies. The CAD has still a ways to fall against the USD. The USD could still fall substantially against the euro, but not without a lot of screaming from the Eurozone countries against America and Asia. The least likely result is that Asian currencies as group will fall against the USD. If anything, when push comes to shove (especially from the Europeans and oil-surplus countries) selected Asian currencies could soar. That is one of the reasons why the fixed-income portions of our global portfolios are now tilted towards Asia.


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