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Unfortunately, markets right now are going through what we would consider a ‘regime change’, which makes things all the more difficult as markets transition into unprecedented territory, or at least an environment investors are not accustomed to. Understanding that ‘those who cannot remember the past are condemned to repeat it’ but also that past performance does not guarantee future results, we wanted to take a look at past currency regime changes and see if there is any clear way to invest in this uncertain environment.
A regime change in investment terms would be when a certain state of the market that investors have been accustomed to has transitioned (or is transitioning) to a new, less familiar one. This means that the factors that were initially driving an economy have changed, become less important or maybe simply reversed. With oil seeing big declines in a short period of time that appear like they will be sustained, the US dollar gaining strength on essentially every other currency and interest rates in the US finally on the rise, albeit modestly so; we think investors are faced with new and unfamiliar territory. We will start with the chart of the Canadian dollar relative to the US dollar over a 20-year period.
We are using this chart to try to see where there might be regime changes in the past. Using the CAD/USD exchange rate as a proxy is convenient for two reasons. First, for Canadian investors, a materially different Loonie has economic implications for investors inside the country. So regardless of the reason for the movement, a big move in the exchange rate should mean something has changed and it can be interesting to see what happens after this ‘something’ has occurred. The second reason it is convenient is because we believe it is a fairly strong proxy for big shifts in the price of oil. We are not talking a 1% up or down day in oil here. We are referring to the Canadian dollar being a good reflection of large and sustained moves in the price of oil. Following on this, oil prices can also be an indicator for general economic activity, so the exchange rate movements may also hint at shifts in the global economy. Just to clarify, as the above chart may look a bit backwards to Canadian readers, upward moves in the chart are a weakening Canadian Dollar (CAD) and a strengthening US Dollar (USD). Upward moves on the above chart can also roughly correlate with downward moves in oil prices. From this we have pinpointed the following timeframes:
- 1992 to 1995
- 1997 to 2002
- 2002 to 2007
- 2013 to present day
1992 to 1995 - Emerging Market Volatility
Starting around 1992, the Canadian dollar saw a sharp decline over what is roughly a two-year period. The US was coming out of a recession in late 1991, which helps explain the reason behind a strengthening USD relative to the CAD as well as an upward trending S&P 500 for the next few years after. The TSX and STOXX both followed suit while Chinese markets were all over the place but still managed to be a significant outperformer. What is interesting about this chart compared to what we will see in the other timeframes is that there does not appear to be any red herring that would move markets substantially. Aside from the usual gyrations of an economy, everything appeared to be fairly normal during this period. There will always be some social or political event that one can point out but there seems to be a lack of any overarching shift that drove markets above and beyond a generally strengthening economy. The easiest nugget to draw on here is likely just that Emerging Markets (China) are volatile but can pay off over the long term. It would probably be a comical exercise to gather news headlines about the Chinese economy at the peaks and troughs of the market, which would have likely encouraged investors to do the absolute wrong thing at the absolute worst time. The real lesson from this chart will become more apparent after viewing the others and bringing the pieces of the puzzle together.
1997 to 2002 - Currency Crisis and Tech Bubble
This chart is a bit more exciting than the last and we have the Asian Currency crisis and the Tech Bubble to spice things up. This period also saw one of the sharper declines in the Canadian dollar, as funds would have flowed into the US, driving up the USD as Asian currencies became devalued in this period. The higher USD also led to a lower price of Gold, which should be expected. Finally, it is worth noting that in 1997 to 1998, we have a fairly large decline in oil which coincides with a strengthening USD and by the end of 1997, we start to see the TSX act quite similarly to oil markets. So far we have two periods of a significant USD appreciation and two periods where all of the equity markets have strong returns while taking different paths. Again, China does its own thing but rewards patient investors. Commodities also struggle with oil flirting with negative territory at multiple points in the timeframe.
2002 to 2007 - The Commodities Awaken
Here we have an emergence of commodities during what is the biggest decline in the USD over a 20-year period. I think at this point one of the lessons (from the past at least) is becoming pretty clear. You do not want to own commodities when the USD is strengthening. However, as the US dollar declines, commodities get their time in the sun. Since commodities are typically priced in US dollars and should be a store of value, these ‘hard assets’ need to increase in order to offset the declines in the currency they are priced in. Yes, an oil investor would have made money with oil in the 1997 to 2002 periods, but they would have done it with much more volatility than developed equity markets. Not surprisingly, the TSX outperforms other equity markets with China coming from nowhere and continuing to be THE best performing equity market in each time period outlined. US and European markets are not much to write home about but do remain positive over this time frame.
Not a member? Sign up for the blog below to be notified each week when we have updated this series with the next part. Or, join now to see the blog in its entirety. Next week we look at the currency crisis and tech boom over 1997 to 2002.