APRIL 25, 2011
Note: The following post is a guest post from John in Ottawa. I've added a few thoughts at the end. -Ben
Why Investors Favour Canada
Canada is an attractive market for foreign investors looking for safe, reliable returns relative to investments made in the United States or in US dollars.
Looking strictly from the point of view of an investor with US dollars to invest, consider what has happened in the US since 2000.
A US dollar invested in the S&P 500 Index in January, 2000 has lost nearly 10% in nominal terms. This is what people mean when they refer to a “lost decade.” However, a Canadian dollar invested in US dollars at the same time would have lost almost 35% in real terms.
Notice the strong negative correlation between the exchange rate and the value of the S&P. When the US dollar is up, the S&P is down and vice versa. This is reflecting the fact that the components of the S&P are large companies with real value outside of the United States. So the S&P really is simply a reflection of the strength or weakness of the US dollar.
Now look at the S&P/TSX compared with the exchange rate.
Here, I’ve inverted the exchange rate. A Canadian investing in the TSX would have realized a real return of about 62% since 2000. However, a US dollar investor could have realized nearly the same return by simply trading US dollars for Canadian dollars. Notice the strong positive correlation between the value of the Canadian dollar and the TSX.
Finally, let’s put it all together.
A foreign investor holding US dollars has many investment options and many risk factors to consider when looking at a total return; geopolitical stability, economic stability, and exchange rates being just a few.
When a foreign investor considers purchasing a condo in downtown Toronto, it is not sufficient to look simply at the price to rent ratio. It is necessary to look at the total return considering exchange rates. Additionally, a Canadian investment must be compared to alternative investments in other currencies and countries. Sometimes an investor is faced with choosing the lesser of two evils; which investment will lose the least.
For now, Canada has been and should remain a good investment option that will provide real positive returns to foreign investors. Foreign investment adds to Canada’s economic stability and provides jobs. It runs the risk that foreign investors are a fickle lot and will run to the next opportunity at the drop of a hat. For now, this seems like a low risk.
Foreign investment will have the affect of supporting housing prices, both directly through investment housing and indirectly by providing Canadians with the where with all to continue to buy and pay for houses. Foreign investment is a mitigating factor when considering house price metrics which might otherwise look precarious. It adds variables and makes forecasting just that much more difficult.
In the short term, the event to watch is the Fed’s Quantitative Easing program. If QE ends, we should expect the US dollar to appreciate and continue to do so for a while.
Over the long term, the Fed is painted into a corner so there is a very high likelihood that QE will be extended well into the future. For the US, it is difficult to know what the end game is. I expect the US dollar to continue to depreciate for a very long time.
Thanks John! Indeed the Fed is painted into a corner. The end of QE2 is perhaps the single most significant event of 2011. How interest rates in the US and beyond will react is a huge question. How will commodities react? I'd love to hear thoughts from the readers on this one.
My own personal opinion is that we will likely see a fall in commodity prices and a rebound in the USD, though I think the monetary metals (gold and silver) will continue to shine, albeit with increased volatility, though that's far from a unanimous prediction. And that, of course, depends on whether or not the Fed actually ends QE. There's a very good chance that it will continue in some form, and any stoppage will likely prove to be temporary.
The Globe and Mail had a good article on this over the weekend: As the easy money ends, an uncharted road lies ahead
It's also worth remembering that many risk assets have shown a strong correlation to the expansion in the Fed balance sheet as QE has progressed:
I'm not sure about foreign investment buoying real estate directly unless, as the work of Demographia suggests, that the demand cannot be met due to building constraints. Even then, I have a hard time believing that rational investors will plough hundreds of thousands into an asset with a cap rate of a few percent (residential houses) when other options are available for them to bet on the stability of the Canadian dollar. Of course that assumes that these foreign investors are rational.....which raises another topic all together.