volatilityA Canadian investor who placed a large portion of their investment portfolio in the United States in 2015 would have vastly outperformed other investors in Canada.

A Canadian investor who selectively picked the correct U.S. value stocks for their portfolio should have had exceptional performance in 2015.

In both cases, the result is not necessarily because the U.S. equity markets performed well during the year (the S&P500 is currently down 2.3% year-to-date), though such markets have outperformed Canadian equity markets (the TSX60 index is currently down 12.5% year-to-date).

The reason for the outperformance in both cases is because of the significant decline in the value of the Canadian dollar relative to the U.S. dollar – as of today, the Canadian dollar has depreciated by 16% year-to-date relative to the U.S. dollar.  The reason stock-picking value investors have had exceptional performance is because a stock-picking strategy had the potential of adding an additional 5-10% investment returns in a diversified portfolio, if the right stocks were selected.  The net result is that successful Canadian investors using a value-based U.S. stock-picking strategy should have seen returns in the range of 15-20% in 2015.

For such investors, this represents unusual excessive returns over the indices, i.e. in excess of 25%.

This exceptional performance reveals the importance of considering currency in asset allocation decisions to overall out-performance.  Even a portfolio of excessive cash positioning would have materially outperformed in 2015 had such cash been held exclusively in U.S. dollars.

What is the prognosis for the Canadian dollar in 2016?  As shown in the following chart, the Canadian dollar moves closely with overall commodity prices.   The reason for the material decline in the Canadian dollar over the past year, then, is because of the material decline in commodity prices across the board (including oil, coal, copper, aluminum, lumber, and so on).  The principle reason for the decline in commodity prices has been because of the slowdown in the Chinese demand for them, due to the slowdown in their manufacturing sector, in turn due to a combination of sluggish exports and sluggish domestic demand in the country.

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The link between oil prices and the Canada-U.S. dollar exchange rate is particularly acute, as shown in the next chart.  There are several important factors contributing to the decline in the price of oil (it was way overvalued; supply is excessive; pessimism in the market place; declining China demand; and so on).

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So, the answer lies in one’s prognosis for the economic health of China, as well as a prognosis for the price of oil.

It is true that the U.S. economy has picked up materially in 2015, and arguably should have offset some of the negative impact of the slowing Chinese economy.  However, the U.S. economy is no longer the major manufacturing economy in the world –many of the U.S. manufacturing companies have outsourced their manufacturing to less-developed countries such as China and Mexico.

Some good news for the commodities market is that, although prices have seen an historic pace of decline, their prices have begun to bottom out, as shown in the following charts (the first showing the historic decline to 2004, and the second showing the pace of the recent decline using 2005 as the benchmark).

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In terms of the oil price, it is now definitely in an oversold position.  There is the possibility of some recovery in its price short term, which will support the Canada-U.S. dollar exchange rate.  However, one cannot predict the exact timing of this.

Will commodity prices see further declines?  Should we expect the Canadian dollar to continue its downward trend relative to the U.S. dollar as a result?  Unfortunately, in the short term the answer is yes.  Until investors see at least a bottoming trend in Chinese manufacturing, they should expect a continuing weak trend in the Canada-U.S. exchange rate.  Thus, Canadian value investors should continue to overweight select U.S. value equities in their portfolios.  The U.S. economy should continue to outperform its global competitors over the short term, and hence there will be select U.S. equities to own.

At the very least, risk-averse Canadian investors who are nervous about their competency in finding those individual U.S. equities to own should maintain healthy cash positions in U.S. dollars.