Strictly: Drilling

[Old Frank P]

** Don Coxe For This Week

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The loonie's new tune
DONALD COXE

Last week, I raised the question of the possible onset of a good news/bad news bear market -- the U.S. dollar. The dollar's slide since January has been good news for Canadians, Australians and Europeans, and has been bad news for holders of U.S. stocks and bonds.

How did the U.S. dollar get so overvalued that it could be subject to a major bear market? In large measure, the dollar's overvaluation was a side effect of the financial excesses of the 1990s. The dollar benefited big time from the tech stock boom, as investors worldwide poured money into the U.S. to get in on the greatest bull market of all time. America had the best technology, the best investment banks, the best media, and the best economic and political environment. Naturally, these superlatives meant the U.S. had the best currency. What is a currency but a paper encapsulation of a nation's economic, political and financial accomplishments?

Nor was the foreign ardour for U.S. assets confined to stocks. The stronger the dollar got, and the more prestigious Federal Reserve chairman Alan Greenspan became, the more foreign investors wanted to acquire U.S. bonds.

So great was this shared enthusiasm that global investors chose to ignore the obvious: the U.S. had the industrial world's lowest savings rate, and the world's largest trade deficits. U.S. manufacturing was engaged in outsourcing on an unheard-of scale because it was so broadly uncompetitive. The greenback was the IOU of a nation that had made an art form of the lifestyle of living beyond one's means.

In recent weeks, global investors have begun an agonizing reappraisal of their U.S. risks. They are heavily weighted in U.S. stocks -- and the U.S. has been the worst-performing of major markets. They find themselves heavily weighted in U.S. bonds whose coupon rates don't cover the depreciation in the U.S. currency since January, let alone what could lie ahead. U.S. short-term interest rates are in the two per cent range -- lower than virtually anywhere except semi-comatose Japan. A two percentage point rise in the euro wipes out a year's income at these trivial rates.

Global institutional investors tend to think currency first, stock valuations second. They know that a big currency move can wipe out whatever edge they might have achieved through good luck or good stock-picking. They also know their clients are acutely aware of currency swings. That recognition was a reason managers kept pouring more money into U.S. stocks even when they complained that the U.S. was by far the most expensive stock market in the world: in traders' jargon, they were skated onside by the currency. Now, with the softening U.S. dollar, they find themselves skating toward open water.

They are already cutting back sharply on new inflows into U.S. assets. The real pain for the dollar will come if they get scared and start to become sellers. The need to finance the $1.7-billion-a-day current account deficit then becomes an overarching problem for the global financial system.

What's bad news for greenbacks is good news for loonies. The Canadian dollar didn't deserve its recent, ignominious valuation. The nation was already recovering from its long years of folly, and it had a new central bank governor who was tough, smart and candid about what made economies tick and currencies perform. If it hadn't been for the last, orgiastic rush into the U.S. dollar, the loonie would never have gotten to 62 cents (and the euro would never have gotten down to 84 cents).

The most obvious effect of the dollar's descent to date is the new global enthusiasm for gold. Gold usually trades inversely to the value of the dollar -- the currency that replaced it as the store of value at Bretton Woods 58 years ago. Should the dollar's decline become a rout, gold will soar.

Foreigners are stepping up their purchases of Canadian equities, wanting to get relatively cheap stocks in a very cheap currency. That process takes a long time to build momentum, because Canada is a small, somewhat overlooked market. But Canada's weight in global stock indices has begun to rise as Canadian stocks outperform U.S. stocks and the loonie surfaces. That process eventually becomes self-reinforcing as even more foreigners rush to load up on the new North American winning investments. Canadian stocks give foreigners access to the U.S. economy at lower price-earnings ratios and in a stronger currency. The Toronto Stock Exchange should be one of the world's best stock markets in the next year.

Naturally, Canadians are the last to believe the worm has turned. A leading Canadian economist recently described his investment strategy as "getting the hell out of Canada into the U.S.," a pronouncement that offers new evidence that economists rarely make capable investment advisers.

In the currency world, what goes down drives something else up.

Plan on a bargain southern vacation next winter.

Donald Coxe is chairman of Harris Investment Management in Chicago and of Toronto-based Jones Heward Investments.

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