It’s All About The Loonie

Canadian investors are once again focused on the loonie. With the Canadian dollar having climbed 5% over the past month to trade at roughly US$0.94, parity with the U.S. dollar seems achievable. The 52% run-up from its 2002 low of US$0.62 has been largely tied to climbing commodity and oil prices. Since the beginning of this year, however, the primary drivers of the loonie’s success have been the stronger than expected Canadian economy and a new wave of merger and acquisition activity.

Of greatest significance is the dramatic change in the outlook for the Canadian econ­omy over a relatively short period of time. Recent economic data have consistently beaten expectations, in some cases by a wide margin. The first quarter GDP growth came in at a blistering 3.7% annual rate compared to the Bank of Canada’s expectation of 2.5%. At the same time inflation continues to be higher than the Bank of Canada’s targeted range. In its most recent Monetary Policy Report the Bank of Canada clearly indicated its biggest concern is inflation and then later signaled in May that markets can expect to see rate hikes over the near term. We now see the Bank in­creasing short-term rates by 25 basis points in both July and September, providing the currency is not too strong.

Despite the positive sentiment and strong momentum behind the dollar we believe that unless we see a further upswing in commodity prices the loonie is likely to moderate slightly by the end of the year and into 2008. BMO Capital Markets Economic Research forecasts the dollar will trade on average at just under US$0.95 during the second half of 2007 and at an average of US$0.92 in 2008.

The latest U.S. economic data is encouraging and suggests the U.S. economy is starting to turn the corner. We are now of the view the improvement in the U.S. economy will keep the Fed on the sidelines longer than expected and no longer anticipate a rate cut in 2007.

May was a difficult month for fixed income investors with the Universe Bond Index delivering a negative 1.44% total return. Looking out over the next 12 months, we believe bonds will do well to deliver their coupon and are likely to underperform eq­uities. We are maintaining our defensive position in bonds to reduce the interest rate

 

sensitivity of portfolios and recommend a short-duration strategy. We suggest total return investors focus on shorter term bonds and structure their fixed income invest­ments with 75% in 1-5 year bonds and 25% in 5-10 year bonds.

The equity market’s advance continued in May supported by stronger than expected first quarter earnings results. Year-over-year S&P/TSX Composite earnings grew by 11% compared to expectations for 10% growth. In the U.S., the S&P 500’s 8% growth in earnings easily surpassed the Street’s modest forecast of 3.5%.

The current fundamental backdrop remains supportive of our overweight equity posi­tion. Based on BMO Capital Markets Equity Research forecasts earnings yield for both the S&P/TSX and S&P 500 are roughly 6%. While we have modest return expectations for stocks we continue to believe equities will deliver better results than fixed income or cash over the next 12 months. Although the rapid rise in bond yields has yet to impact the equity market we are mindful of the potential for yields to put a damper on equi­ties, especially if longer term bond yields surpass and remain meaningfully above 5% for a sustained period of time.

We are maintaining our healthy foreign equity allocation to reflect our commitment to diversification within portfolios given the narrow focus of the Canadian equity market. We recognize the loonie presents investors with a headwind however we continue to believe the diversification opportunities and attractive valuations outside of Canada offset the potential currency risk.