Beyond the Border

Now trading below US$65/barrel, oil is down approximately 17% from its July highs. Gold is down about US$145/oz from the 26 year high it set in May 2006. At the same time, base metals prices have declined over the past three months. The sell-off in commodities has been triggered, in part, by growing concern over a slowdown in global economic growth and the anticipation that this will lead to a reduction in demand for commodities.

Against this backdrop, it is not surprising the S&P/TSX Composite Index has struggled in recent months. With 46% of the index in energy and materials, its performance will be influenced by the outlook for the global economy and by extension, commodities. It also means that Canadian equity investors have had to accept the index is likely to be more volatile due to its high concentration in two cyclical sectors.

We believe the recent market volatility serves as a reminder of the importance of international diversification within investment portfolios. Not only to help control the effect of being exposed to weakness in the domestic market, but also to provide exposure to greater breadth and/or a different mix of industries than is available domestically. Canada comprises roughly 4% of the world equity market ie. 96% of global equity market opportunities are outside of our borders (see Chart). Furthermore, the opportunities available in foreign markets are often more diversified than those in Canada, such as well-established multinational corporations.

Historically, Canadians have tended to favour domestic investments. The relative outperformance of the Canadian equity market and the strength of the Canadian dollar in recent years have further fueled this home country bias with many investors increasing domestic holdings.

The headwinds created by the rising Canadian dollar have eroded returns on foreign holdings in recent years. This clearly highlights one of the most significant risks associated with foreign investments: currency risk. While this has been frustrating, it does present investors with an opportunity to acquire foreign investments while the loonie is strong. Although the Canadian dollar is likely to remain firm over the next year, we also believe there is limited further upward potential for the currency, capping the near-term exchange rate risk of investing abroad for Canadian investors.

We have begun to see a shift in the markets with the more defensive sectors outperforming as investors reposition their portfolios in anticipation of an economic slowdown. They are turning to stocks that are less dependent upon the economic cycle and therefore better able to provide consistent earnings and dividends. Typically this would be: financial, health care, utilities, and consumer staples. The problem with the Canadian equity market is that, with the exception of the financial sector, our choices in these areas are relatively limited. We believe that investors need to ensure their portfolios are not excessively weighted in either Canadian equities or the more cyclical sectors of the market. Given the concentration of the domestic equity market in these relatively few sectors, we recommend investors turn to foreign markets for exposure to those areas of the Canadian equity market that lack depth.