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Loonies and bears: a cold, hard look at the Canadian market

This advisory sees some hope in the Canadian resource sector, but predicts belt-tightening in Canada and a long cleanup in the U.S.

The loonie is coming home to roost. The high Canadian dollar is taking its toll on businesses across the country. So is the credit morass in the United States.

In fact, the whole thing is a bit of chicken vs. egg (or loon vs. egg, if that seems more appropriate). The rise of the Canadian dollar mirrors the weakness of the American dollar. But it was also spurred on by foreign takeovers of big Canadian companies.

In turn, a U.S. economy softened by financial weakness cuts into the market for Canadian exports. And now they cost a lot more to buy with the swing in currency exchange… it’s not always easy to sort out the head from the tail of this monster.

But it will be easy enough to see the affects as time goes by. They are already under way, according to Ian McAvity’s Deliberations on World Markets.

“Almost every day there are stories of an enterprise or project cutting back or shutting down some operation because of the impact of the high Canadian dollar,” says this advisory in the opening of its Canadian Market Comments.

We’ll follow Mr. McAvity in his relentless chain of reasoning, and then see why he thinks the credit mess south of the border may take much longer to clean up than many people think.

It’s worth noting that he has a significant U.S. readership and his commentary helps these American investors gauge the advisability of putting their money into the Canadian market.

Three psychological phases

“It took longer than I expected for such stories to emerge,” says Mr. McAvity of the cutbacks in Canadian industry. He refers his readers to a series of charts that track the progress of each segment of the economy. They demonstrate that the non-resource sectors “have all broken down quite harshly, except for the defensive Utilities.”

The editor then explains what we can expect in the months ahead.

“There tend to be three psychological phases during the course of a bear market,” he says. “The initial breakdown phase, that’s been underway for about seven months since the TSX Unweighted Index peaked in July, might be best labeled the Denial phase.”

This phase was based on several strains of optimism that appear to be fading away. “Nobody believed a recession would be ‘allowed’ to happen (as if central bankers really have such magical powers) and the Chinese demand for Canadian commodities would somehow insulate Canada from U.S. demand slowing, despite the fact that a lot more Canadian jobs are involved in making stuff to export to the U.S.”

We are now passing into the second phase.

Reality sets in

“In the second phase of a bear,” explains Mr. McAvity, “reality sets in, as the facts of projects scaled back because of cost overruns start to surface.”

Now it becomes evident that a recession is looming, something the editor’s charts were predicting some time ago, he adds. “It’s amazing how a flow of facts can screw up an otherwise perma-bullish story on Bay Street months after it was apparent on the charts.”

Now it is time to admit the truth. “The third, final phase of a bear is the capitulation phase with fear the dominant emotion, not bottom picking by the talking heads.” In short, rather than calmly suggesting investors pick up bargains during a market correction, the army of experts begins sending out strident alarm signals.

Not all hope is lost for Canada, however.

Insulation and elections

“I don’t doubt the resource sectors will insulate Canada to some degree relative to the U.S.,” comments Mr. McAvity. But this does not make Canada a strong diversification alternative for U.S. investors.

Look at the chart comparing the TSX and the S&P 500 in terms of U.S. dollars, he says. Between 1999 and 2001, the TSX offered a spectacular run for U.S. investors.

What can they expect for an encore today?

The Canadian dollar has appreciated more than 60 per cent since then, cutting into the value U.S. investors get on the Canadian market. And if the dollar goes higher, things will get even worse.

There is no way it will rise like that, says the editor, “without unemploying the bulk of Canada’s labor force.”

The prospect of an election isn’t liable to change the picture. “The Conservative government may be about to force an election while the primary opposition Liberals continue in disarray. (Better now than later if the economic slump may be accelerating.)”

“I doubt they’ll get a big majority as none of the leaders generates much excitement,” he adds. Income trust investors may get a faint whiff of hope, however. “Liberals may try to bribe embittered trust investors with proposals to roll back the unpopular tax that damaged trusts in October ’06.”

As for the Canadian dollar, Mr. McAvity thinks it is possible it may yet make another sharp rise after a brisk pullback from its November high. But in the long run, the loonie is liable to move down gradually. Foreign takeovers are less likely to spur it on, he says, “and as one portfolio manager wryly noted, we’re running out of big companies that might attract takeover bids.”

Investors who follow the dollar might find support around 95¢, or may wish to wait for an even better re-entry level of 91 or 92¢ later in the year, advises the editor.

South of the border, the direction continues to be down.

Year of the Rat

“Credit as we know it may be very different for a long time to come,” states Mr. McAvity. “Hundreds of billions of write-offs are yet to come. Political talk of freezing mortgage renewal rates suggests a basic tenet of contract law may be sacrificed in the name of buying votes. If that notion gains traction, much higher future mortgage costs will result.”

He is equally critical of a proposal by the British Chancellor of the Exchequer that the Bank of England should provide secret help to failing banks in order to buttress consumer confidence. Talk about putting the “con” in confidence, notes the editor sharply. (And indeed, this has been followed up by the British government taking control of the failed Northern Rock mortgage bank.)

Meanwhile, the U.S. Federal Reserve Board keeps cutting rates, which means hyperinflation may be closer than we think, adds the editor.

“There are many more credit and CDO [collateralized debt obligations] cockroaches yet to emerge,” warns Mr. McAvity, who has no kind words for the perpetrators of this mess. “Major charges against the bankers and credit raters who conspired in this fee-generating fraud should be forthcoming.

“How timely that Chinese New Year just rang out the Year of the Pig and we’re now in the Year of the Rat!”

$100 bills in the parking lot

The creation of new credit will be frozen for some time, concludes Mr. McAvity, and new debt will be hard to come by. The economy runs on credit and debt. “I fear this will boost the length and depth of the recession.”

Attempts to keep Americans spending are all doomed to failure, in the editor’s opinion.

Mailing out tax refunds that add directly to the deficit is simply a politically expedient election year sham, he says. Throwing money at the banks isn’t any better. “The Fed is simply pushing on a wet noodle, pouring funds into black holes in the banks.”

If you want to promote retail spending, he adds sardonically, you’d be better off dropping $100 dollar bills in Wal-Mart parking lots — “and the Chinese suppliers of Wal-Mart will be very grateful.”

The NYSE Financials have given back 53 per cent of the points gained since their low in 2002. Those seeking to scoop up bargains in the market can only hope that most of the damage has already been priced in. But things will not be getting better sooner, in Mr. McAvity’s view.

“It will take years to work out the credit mess, as the twin handicaps of capital inadequacy and hyper-risk consciousness chills the reckless lending that fueled growth in the past decade. It may be a long time before the financial arena turns around.”

If there is a silver lining for Canadians in this black-cloud vision of the markets, it appears to lie in our natural resources. We can only hope that the Year of the Rat is also the Year of the Rock, the Tree and the Oil Well.