Why investors favour Canada
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.
Ben's thoughts:
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.
Cheers
Ben
6 Comments
Interesting analysis. We can figure out what a rational foreign investor would require for a CAD-denominated return vis a vis other jurisdictions by looking at currency forwards but even then most analysts I have heard speak are more uncertain about exchange rates than about any other metric. So while we can say that investors are accepting a lower yield by projecting of long-term exchange rate differentials, I have yet to see a collective group of analysts sage enough to get it right. More than a few Americans invest in commodities too!
On the rental yield front, we should remember that, while foreign investors may have certain yield expectations based on two countries' long-term currency spreads, they still are competing at the margins with local investors/owners who want local returns. Further, if one believes that certain Asian currencies are due to appreciate as well as they become "developed", one would expect that to elevate their foreign investment yields, even one on as strong a tear as Canada's.
Good post though.
Interesting analysis. We can figure out what a rational foreign investor would require for a CAD-denominated return vis a vis other jurisdictions by looking at currency forwards but even then most analysts I have heard speak are more uncertain about exchange rates than about any other metric. So while we can say that investors are accepting a lower yield by projecting of long-term exchange rate differentials, I have yet to see a collective group of analysts sage enough to get it right. More than a few Americans invest in commodities too!
On the rental yield front, we should remember that, while foreign investors may have certain yield expectations based on two countries' long-term currency spreads, they still are competing at the margins with local investors/owners who want local returns. Further, if one believes that certain Asian currencies are due to appreciate as well as they become "developed", one would expect that to elevate their foreign investment yields, even one on as strong a tear as Canada's.
Good post though.
Of course, if the NDP and Liberals form a formal coalition (majority) government with Layton as PM, all bets are off.
We've never had one in Canada, but a formal coalition is a written contract between parties laying out the terms of the coalition. The coalition forms a majority government that can't be taken down.
It will be very interesting to watch how this all unfolds. Will the Liberals join with NDP policies, bigger government, cap and trade, higher corporate taxes, etc., for the sake of a few cabinet seats?
What will be the view of foreign investors (think the bond market) to a truly socialist government in Canada? I would think the bond market would, at the very least, be a bit wary.
And where is Iggy in all of this? After this election he is going to need to step down as leader.
So this is what a Canadian Black Swan looks like!
The idea that the end of Q2 will change anything is not serious.
Markets are forward looking and all this information is priced into the market right now. End of QE2 is not a surprise event, it well known in advance and fully priced in.
Nothing will change at the end of QE2 market wise. We will soon find out.
Yes, we know all about QE II. The Fed did a good job of telling us all about it well in advance and the start of QE II was completely priced in. What is less well known, and subject to a great deal of speculation, is whether there will be a QE III, IV, etc, how far down the pike they may be, what they will look like, and will the Fed signal them in advance.
So, yes if QE II ends as scheduled and no QE III is signaled in any way, then we know fairly well how the US markets will react at that time.
QE2 was a consideration even before QE1 was off the presses, and so is QEn. We should remember that the US economy is beginning to recover -- slowly, but still recovering -- and QE[1..n] will eventually be wound down again. By all accounts that will happen starting 2015, or maybe a few years later, and by no coincidence looks to coincide with a return to normalcy in the construction industry.
Do you think that the existence of QE automatically devalues the US's currency?