Canada is having a rough start to 2014.  We’re not talking about the ‘Polar Vortex’ that is making for the most bone-chilling winter cold we’ve seen in decades or the daily trials of Toronto’s Mayor as he is regularly ridiculed on late night television or even Justin Beiber, with his headline catching arrests in Florida and Toronto.  The real damage being done to Canada is the depreciation of the Canadian Dollar as global investors fret over high consumer debt levels, slowing economic growth and an implosion of commodity prices, the lifeblood of our economy.  International investors are worried that debt-laden Canadians are becoming more susceptible to economic shocks.  The new mantra is that Canada’s economy is in danger of underperforming the U.S. as consumers becoming increasingly fragile amid rising household debt and home prices.

The big fear seems to be that what ails emerging economies will occur in Canada.  Any country that needs external (foreign) financing to fund its debt becomes more at risk when these capital flows slow down.  Often we see interest rates pushed up aggressively in order to keep capital in that country.  We have seen that this week as Turkey got much more aggressive on rates to stem the flows of capital that have undermined its economy.  Turkey’s central bank unveiled emergency interest-rate hikes that more than doubled its benchmark one-week lending rate for banks to 10% from 4.5%, in an apparent effort to quell volatility and get the banks to hold money longer.

However, we don’t see this situation as worrying as the market is indicating.  First of all, Canada’s economy is ultimately too closely tied to the U.S. to have our growth rates diverge dramatically for any period of time.  As the U.S. economy expands, so will our exports in industries such as autos and home building products.  The supposed link between Canada and the emerging economies is also not as close as investors currently fear, given that it is more of an ‘indirect link.’   Since Canada remains a ‘hewer of wood and a drawer of water’ (i.e. we produce and export basic commodities and tend to import more finished goods), the value of our currency has always been tied very closely to the level of commodity prices, as shown in the chart below.
Weak commodity prices = weak $CAD

Meanwhile, the emerging economies of the world have been the biggest driver of commodity prices over time since they are responsible for more than 100% of incremental commodity demand (the developed economies of the world, such as Europe, Japan and the U.S. tend to decrease their per capita use of commodities and therefore add no growth).  So we can see where there is a link from emerging economy growth to the Canadian dollar, but it is far from a good lead indicator of Canadian economic growth.

The bottom line is that we don’t see the problems in Turkey or Argentina as being anything that should undermine the outlook for our economy or the  value of our currency.  This is not unlike the situation we saw last year when foreign investors became large short sellers of our banks on the view that, as lenders to home buyers, the banks would be most at risk as housing collapsed.  Neither outcome came to pass, though, and banks ended up rallying sharply for the rest of 2013.  Home Capital Group, the biggest player in uninsured mortgages in Canada, rallied more than 65% from its May low to year end!

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