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Turn Out The Lights, The Parity Is Over.


Yesterday, CFA Vancouver hosted a Bloomberg sponsored presentation by the Bank of Canada’s Dr. Farid Novin. Bloomberg stole the show.

Bloomberg’s intent was to tout their online analytic and trading tools. They are impressive.

Bloomberg addressed three areas of interest to all investors – Currencies, Commodities and Bonds.

First, currencies.

Bloomberg spoke about the Canadian dollar and to currencies in general. The expert speaker might as well have said ‘turn out the lights, the parity is over’ as Bloomberg’s long-term valuation tools paint a bearish picture for the Loonie.

On a Purchasing Power Parity (PPP) basis (which looks at a collaborative basket of goods across economies), the Loonie is Fair Value (versus the U.S. dollar).

On a Consumer Price index (CPI) basis, the Loonie is overvalued by ~ 20%.

Based on the surprisingly accurate Ecomonist.comBig Mac’ index, (which celebrates it’s 25th birthday this week), the Loonie is roughly the same as the CPI index ~ 20% over valued.

Economist.com, Big Mac index

 

 

 

 

 

 

 

 

 

 

 

 

 

The Bank for International Settlements (BIS) tool says the Canadian dollar is 18% overvalued.

The International Monetary Fund (IMF) has four approaches to valuation. PPP, CPI, Trade weighted and on a Real Unit Labour Cost basis (i.e. Wages). Again, the Loonie is overvalued.

Bloomberg weighs these longer-term valuation tools against how the market values the Canadian dollar and survey’s sixty currency analysts. Bloomberg argues that this is the ‘reality’ view versus the above ‘subjective tools’ view. Even so, this ‘real’ view shows most expect a weaker Canadian dollar going forward.

Bloomberg also uses a ‘peer correlation’ valuation measure which shows the Canadian dollar correlated to the U.S. stock market index, the S&P 500, at the .9 level over the last ninety days. This means the Loonie has moved in lock-step with the U.S. stock market. (Surprisingly, oil is only correlated to the S&P 500 at the .5 level). This signal’s that the markets are not tied to the fundamentals of the economy.

Bloomberg looks at the Bank of Canada Commodity index. The Bank of Canada philosophy is that commodities are the key drivers of the Canadian currency. This is clear from the chart below.

Bank of Canada, Commodity Price index

 

 

 

 

 

 

 

 

 

 

 

Finally, Bloomberg looks at short-term positioning by way of capital flows and separates out flows from Merger and Acquisition and/or portfolio activity (Cold money) from speculative flows (Hot money). Guess which one is en-vogue?

Is the Canadian dollar overvalued?

Not one Bloomberg valuation tool says the Canadian dollar is undervalued. One says it’s Fair Value. The rest say it’s overvalued. This is contrary to what Canadian’s have been hearing and experiencing daily. But when all the signals flash that the Loonie is over valued, Institutional money is sure to follow.

Bloomberg suggested that, persistent over or under valuation outside a 20% band around Fair Value, is where decisions are affected. Investment decisions like ‘do I stop hedging at this point because my hedge helps only when the Loonie is rising’ … and the Loonie is more likely to fall than rise from here. Business decisions like ‘do I move my factory to the U.S. or Mexico’ because the Canadian dollar no longer offers a relative cost advantage.

What might this mean for Investors?

If Bloomberg is right, the Loonie is inflated and has more purchasing power today than it is expected to have in the near future. So investors are faced with a predicament. Do they add to their U.S.investments today with a higher Loonie? Or do they bet on cheaper U.S. investment valuations down the road?  Do they shop for an iPad south of the border now with a higher Loonie or wait for sale prices should the U.S. economy slip into another recession?

Sometimes it’s best not to bet and settle on a half-now, half-later strategy.

Tomorrow’s post regarding Commodities and then Bonds might help you decide.

Meanwhile, see my November 15, 2007 post: Loonie Bets.

Next time?
Bloomberg on Commodities.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan
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5 Comments Post a comment
  1. If you don’t mind my asking, do you make good money from this blog?

    Like

    September 1, 2011
    • Blog’s make money thru advertisements. WordPress has a 50/50 arrangement with it’s bloggers.

      Like

      September 2, 2011

Trackbacks & Pingbacks

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