Avoid the dollar. Which one? Both of them

The softening Canadian economy will be a headwind to the Canadian dollar in coming quarters. As we covered in last month’s commentary, we think the Bank of Canada (BoC) is done hiking. In its October Monetary Policy Report, the BoC slashed growth projections for the Canadian economy. For the first time since inflation picked up in the second half of 2021, the BoC estimates that the output gap is around neutral, which is to say the Canadian economy is back into balance. The BoC’s forecasts have been especially inaccurate in the post-pandemic period, but this time we agree with their expectation of a slowdown.

The outlines of a slowdown are emerging in Canada, while the US still looks rock solid

Trends in economic indicators, Canada vs. US

While the BoC is likely done hiking, we don’t expect rate cuts any time soon. The BoC will be tiptoeing on the 5% tightrope for a couple quarters. Growth and employment data will be too soft to justify hikes, but inflation data will remain too hot to allow for cuts.

Rate cuts in advance of other developed economies would be a clear catalyst for Canadian dollar depreciation. Because we see low odds of cuts in Canada, we’re not positioning for a collapse in the loonie’s value. But we do expect it to weaken against most global currencies. In our Global Macro Fund’s universe of twenty-three currencies, CAD is among the ones we like the least.

Speaking of currencies we like the least, the US dollar is also near the bottom of the pack. The US economy is on better footing than the Canadian economy. Evidence of softening economic data is sparse, fiscal policy will remain expansionary and business investment is solid. We even expect the US Federal Reserve to hike to 5.25% in the coming months, a non-consensus view which would be supportive for the US dollar’s value. But even if the macro backdrop is constructive for the US dollar, the currency is simply too expensive.

The US dollar remains expensive against other global currencies

US dollar real effective exchange rate, deviation vs. historical average

Source: Bloomberg

Fair value must always be an anchor when investing in currencies. Suppose a stock has great growth prospects but is trading at a price-earnings ratio of 40. Would you buy it? Likely not. An investor shouldn’t ignore valuation in equities, regardless of the fundamentals, and the same principle holds for FX.

The US dollar is currently severely overvalued relative to other currencies, while the Canadian economy’s prospects are uniquely dim. Those two forces more or less cancel out and leave us without a strong preference for one currency over the other. Luckily, we aren’t restricted to those two currencies. In our Mackenzie Global Macro Fund, we regularly take positions in twenty-three different currencies, with the possibility of taking positions in others outside of that universe if we sense an opportunity.

The US dollar is the most overvalued of all advanced economy currencies

Long-term fair value vs. US dollar

One of the long-running themes in our currency positioning is our fondness for Latin American currencies. After a few rough years at the end of the 2010s, and a major negative shock in 2020, LatAm currencies were left extremely cheap. Then, in 2021, LatAm countries’ macro profiles began brightening noticeably. A surge in demand for commodities helped right-size their external balances. And their central banks started hiking rates well in advance of those of richer countries. Brazilian rates were up to 10.75% when the Federal Reserve began hiking in March 2022.

Fast forward a few years, and we still like LatAm currencies. But we’ve reduced the size of our positions on that front. While interest rates are still high and balances of payments haven’t deteriorated, LatAm currencies are not dirt cheap anymore. That tends to happen when currencies appreciate at double digit rates, like most LatAm currencies have over the past couple years. These days, we particularly like the Colombian peso, but our long-standing flings with the Mexican peso and Brazilian real are still going strong. We prefer LatAm currencies to EM Asian currencies, especially the Philippine peso and Thai baht, commodity exporters whose external balances have severely deteriorated over the past few years.

In the G5 space, we like the Japanese yen’s prospects as a defensive currency. It pairs well with our LatAm longs, pro-growth currencies with high interest rates. In contrast, the Japanese yen has suffered in the ongoing global inflationary boom, leaving it severely undervalued relative to its long-term fundamentals. In our view, in the case of a global economic slowdown — not our base case, but still a possibility — the yen would be one of the best assets to own in a portfolio. Diversification is key, even in currencies!

Recent economic data suggests China’s Q2 downturn likely bottomed out in July, and that the economy has been stabilizing. GDP data for Q3 was better than expected, while retail sales and industrial production bounced in September. Consumer prices have exited deflationary territory over the past few months. New loan creation seems to have stabilized at around 20% of GDP annualized, a strong enough pace to keep the Chinese economy from entering a more acute downturn.

Most encouraging are signs that Chinese leadership is ready to take steps to extend support to struggling households. Since September, it unveiled programs for down payment support and a debt swap mechanism to ease pressure on over-leveraged local governments.

The Chinese government recently announced a one trillion yuan ($137 billion) stimulus package to lift the economy out of deflationary territory. This will cause the central government’s budget deficit to exceed the informal limit of 3% of GDP. This willingness by the central government to ramp up borrowing is a great sign for the economy’s short-term prospects. One of the main macro problems in China is that debt is hiding in all the wrong places. While homebuilders and local governments are up to the neck in bad debt, the central government’s balance sheet is squeaky clean.

China won’t get back to the high-single-digit growth rates it experienced in the 2000s and early 2010s. New infrastructure investments are unproductive after years of overbuilding, and gains through exports will be tougher to come by. The government’s best bet to return to growth is to encourage household consumption, instead of following its old policy of transferring income from households to exporters. We don’t expect such a major policy shift without a change in leadership. But a stabilization of domestic growth is likely. And a stabilization is all China-linked assets need to rally from their depressed valuations. 

Chinese GDP came in above expectations in Q3, is now in line to hit growth target