The Euro Tentacle

Canada is rich with commodities and notable Austrian economist, Marc Farber argues that commodities typically have 20-year secular bull cycles and bear cycles. The bull cycle for commodities started at the beginning of this decade and therefore, theoretically, has another ten years to go. This would support the assertion by Sherry Cooper, BMO Nesbitt Burns Chief Economist, which said that Canada is going to have a “golden decade” for the next ten years. We certainly have good reason to believe this. Our fiscal house is in good order, our banking system is arguably the strongest in the world, our unemployment rate has risen but not as much as the U.S. or Europe, we have low interest rates and inflation, house prices have held up and strong GDP numbers were announced in Canada last week. GDP came in at 6.1% annualized for the 1st quarter of 2010 last week. We were the first G7 country to raise our central bank rate. This is all great news but a bigger Octopus with a lot of tentacles is overshadowing these positive reports. In the Saturday, June 5, 2010, Globe and Mail Report on Business, Jeremy Torobin and Tavia Grant reported, “But in the interconnected world, even Canada’s rapidly rebounding economy could be at risk should conditions in the U.S. or Europe deteriorate because of the effect that could have on Canadian stocks and commodity prices, and on demand for Canadian exports.”

Let’s consider the Euro, one tentacle of the Octopus. Even though the Euro is a big pond and a continent away, it could take the shine off a golden decade for Canada. The Euro has been deteriorating over the last year. Relative to the Canadian dollar the Euro has moved from about $1.60 to as low as $1.26 (EUR/CAD) and relative to the US dollar, $1.50 to $1.20 (EUR/USD). This could slow down the Canadian economy in a number of ways, both directly and indirectly. Directly, it makes exports from Canada to Europe more expensive. Granted, roughly 75% of all Canadian exports go to the U.S. so the currency valuation between Canada and the U.S. has the most significant impact on our economy. However, a growing trend is exports to countries beyond the U.S. Five years ago exports from Canada to the U.S. represented over 80% of our total exports. According to Stats Canada, export growth in the last 5 years has occurred between Canada, Europe and Asia. If this trend continues so will the impact of a devalued Euro for Canadian exporters.

Indirectly, the devaluation of the Euro relative to the U.S. dollar has a two-pronged effect on the Canadian economy and markets. The Chinese Yuan is tied to the U.S. dollar. Therefore any exports from China to Europe will also be more expensive for Europeans. Some are speculating this has the potential to slow growth in China. If growth slows in China, Canada will be impacted because Chinese companies will demand less from Canada. Again, assuming a growing trend towards exports to China means a growing impact over the next ten years. The second indirect effect is on the markets overall. The carry trade will eventually breakdown. The carry trade is when investors borrow in a low interest currency and invest in a high yielding commodity based currency, like Canada. When the Euro devalues, it becomes more expensive to borrow at low interest rates in the U.S. and Japan and invest in countries with strong commodities, like Canada. Eventually that has an impact on the value of the markets.

The value of the Euro is just one example of the tentacles that have a grasp on how our economy and our markets will perform. Despite all the good things in Canada we have an Octopus on our back that may take the shine off our golden decade.