The U.S. dollar continues to climb against most global currencies – a trend that is nothing but bad news for the Canadian equity benchmark. But, there are signs of excessive optimism regarding the greenback that could provide Canadian investors with an excellent chance to shift portfolio assets from Canadian to U.S. equities.
The past decade has seen the Canadian equity market move consistently in the opposite direction of the U.S. dollar. This has been true of the S&P/TSX composite index as a whole, but the inverse relationship between the dollar and the S&P/TSX materials index has been particularly strong.
Our chart compares domestic materials stocks with the U.S. trade-weighted dollar index – a weighted average of the greenback's value against the currencies of all of the United States' major trading partners. Unlike the loonie-U.S. dollar exchange rate, the dollar index reflects the increasingly important role that emerging markets and global economic activity have played in domestic market returns in recent years.
The chart highlights the inverse relationship between the dollar index and domestic materials stocks – the S&P materials index moves in the opposite direction of the trade-weighted dollar. The chart implies that domestic materials stocks have not fully adjusted to the recent dollar rally and may have further to fall.
Drilling down to individual stocks in the materials index, market patterns since 2004 suggest that Potash Corp. of Saskatchewan Inc., copper miner Capstone Mining Corp. and Major Drilling Group International Inc. have the most to lose from a rising U.S. dollar.
There is good news, however, for domestic investors concerned that they've missed the rally in U.S. dollar-denominated assets. According to U.S. Commodity Futures Trading Commission data, the number of hedge funds betting on further gains in the dollar has reached such extreme levels that a correction is likely. The number of outstanding futures contracts on the trade-weighted dollar index is now higher than at any point since the financial crisis, well beyond the high levels in June, 2012, and March, 2013, that immediately preceded a temporary downdraft in the U.S. currency.
The factors driving the U.S. dollar higher against the Canadian dollar and most major currencies – the end of the U.S. Federal Reserve's quantitative-easing policy and the slowdown in emerging-market growth – strongly suggest an extended rally for the greenback. Domestic investors should take advantage of any short-term weakness in the dollar index to reduce domestic materials exposure and add U.S. dollar assets to their portfolios.
SOURCE: Scott Barlow/Bloomberg
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