How to benefit from a declining US dollar

Is the strength in the Canadian dollar good news for your investments?  It really depends on where you are currently invested.  If you’re primarily within Canada you may have felt little impact from our dollar rising to parity with the greenback.

Canadian investors most affected are those who have greenback-denominated investments as U.S. investments are negatively impacted when the U.S. dollar deteriorates.

We pay our bills in Canadian dollars and must calculate investment returns in the same way.  People with investments in the United States or other foreign securities should track the foreign exchange rate on the date of each purchase and sell.  Upon selling a position you will need to report the capital gain or loss in Canadian dollars on your tax return for taxable accounts.

Share Illustration

Four years ago an investor purchased 200 shares of General Electric (GE) at $30 US when the exchange rate was 1.00 USD to $1.40 CDN.  The adjusted cost base of the purchase in GE is $8,400 CDN ($30 x 200 x 1.40).

Let’s assume that GE is trading today at $41 USD and the CDN exchange rate is equal to the U.S.dollar.  At first glance the investor looking at their investment statement may feel they have a capital gain, after all the stock has increased from $30 to $41.  If the investor were to sell these shares today, the proceeds for Canadian tax purposes would be $8,200 CDN ($41 x 200 x 1.00).  The investor would realize a capital loss of $200 CDN even though the share price had increased by approximately 36 per cent.  The exchange rate difference resulted in a capital loss.

Currency exposure should play an important component of any investment decision including bonds, money markets, bank accounts, etc.  Prior to the end of the 2007 taxation year we encourage you to review your foreign denominated holdings.  To analyse the currency impact, you will need to determine the date you purchased your investment along with the exchange at that time.  This will assist you in estimating the adjusted cost base in Canadian dollars.  If you are unsure of the foreign exchange rate on a given day you may look it up on a foreign currency website such as www.oanda.com.  The next step is to look at these same holdings and calculate the current market value in Canadian dollars.  You may be surprised by the outcome of this exercise!

For the last couple of years many economists have been forecasting that the Canadian dollar would get stronger relative to the U.S. dollar.  Many investors avoided investing in U.S. denominated securities for this reason.  Now that we are at parity, what should investors be considering?  When seeking out U.S. denominated investments the following tips should be considered:

Tip 1 – Settlement

Investors with registered (RRSP, RRIF) and non-registered (cash, margin) accounts should consider the most advantageous place to hold foreign denominated securities.  If you have the option, we recommend holding foreign denominated securities within non-registered accounts.

Transactions within registered accounts settle in Canadian dollars.  Non-registered accounts can hold foreign currencies and also settle those transactions in that currency.  This applies to the initial purchases, income payments, and sells.

Tip 2 – Currency Spread

Every time one currency is converted to another there is a cost to the investor.  Some places may charge a service fee or transaction cost.  The biggest cost is the difference between the price that investors buy at (the bid) versus the price that investors sell for (the ask).  This is commonly referred to as the spread.  If your investment is held in a non-registered account you should consider maintaining a U.S. component.  You may ask your financial advisor to settle the transaction in U.S. dollars.  Proceeds from the sell of one U.S. denominated company may be used to purchase another U.S. investment without conversion costs.  Interest and/or dividends from U.S. investments may also be paid in U.S. dollars.

Tip 3 – Taxation

Certain foreign income is subject to a withholding tax and may be an absolute cost to you if the underlying investment is held in a registered account.  If the foreign investment is held in a non-registered account then Canadian residents may be able to claim a foreign tax credit for the amount withheld on their income tax return.

Tip 4 – Sectors

Many investors may feel that investing in the U.S. provides diversification by geography and currency.  Another great reason to consider foreign investments is to obtain exposure to different sectors.  Canada is very strong in the resource and financials sectors.  Countries such as the U.S. often play a part of a diversified portfolio in sectors such as consumer goods, technology and health care.

Tip 5 – Defensive Stocks

The term defensive stock is used for those companies whose financial results are not highly correlated with the larger economic cycle and will generally have better performance during recessionary periods.  Defensive sectors include utilities and consumer staples such as food, beverages, prescription drugs and household products.  Fear of a U.S. slow down or recession may be one reason why some investors may want to focus on Canadian domiciled investments or those outside of North America.  Some of the best defensive names are in the U.S.  Many of those same companies have significant international operations which may safeguard against a domestic slowdown.

Tip 5 – Time Horizon

Some economists are forecasting further strength in the Canadian dollar relative to the U.S. dollar.  Unfortunately no one knows for certain which way currencies will move.  Several variables impact the direction of currencies and may result in further weakness in the US dollar in the short term.

Investors with a longer-term time horizon and the risk tolerance to withstand currency fluctuations should look at all possible outcomes, this includes a U.S. dollar that begins to appreciate during your time horizon.

The argument for diversification and holding U.S. dollar investments makes even more sense when our dollar is strong and U.S. investments are cheaper.  Movements in a foreign currency may have a greater impact on returns than the movement in the stock price.