As he points out in today’s Breakfast with Dave: Market Musings & Data Deciphering, Australia has a great deal more exposure to accelerating growth in China. Only 3% of Canadian exports go to China while 24% of Australian exports go there. Furthermore, Canada has much greater exposure to the moribund U.S. consumer: 75% of its exports go to the U.S versus 6% for Australia.

Yet, interestingly, the Aussie dollar lost ground after the central bank’s latest rate hike in a “sell-the-news-buy-the-rumor” kind of move. Bank of Canada Governor Carney no doubt noticed that response and might accordingly be less fearful a rate hike would strengthen the loonie (as happens most of the time due to capital inflows). And no doubt he would love to raise rates to head off the bubble-like conditions fermenting in the housing market – especially if the loonie remains well behaved and doesn’t inflict any more pain on the already hard-hit export sector.

That’s because of the historical tendency of the U.S.-Canadian dollar exchange rate, which is to move between $0.70 (U.S.) and $1.05 (U.S.). When an investor buys near, or at, the historical upper boundary, the loonie will in all probability be trending back down sometime within the next few years. The flip side of this move, of course, is an upward trend in the U.S. dollar, i.e. U.S. assets held by Canadians will be basking in the glow of currency gains.

In addition to this historical tendency, there are several other factors to suggest putting more eggs in the U.S. basket as the loonie moves closer to its upper boundary:

• The loonie is presently overvalued by 20% according to the purchasing power parity doctrine

• Loonie strength has been fuelled by signs of a greater recovery in the Canadian economy but the soaring loonie is offsetting policy stimulus while the falling U.S. dollar is adding to U.S. stimulus — so relative growth rates should shift over time in favor of the U.S. and support the its currency

• The Bank of Canada hasn’t intervened in foreign exchange markets since 1998 but it and the federal government have been jawboning about the hazards of a high loonie for months, so the hands off policy on currency intervention could be reversed at some point, especially if the loonie surges past parity

• Unlike other past run-ups in the loonie, this one is occurring with a deficit in the trade balance and while inflation is diving below the Bank of Canada’s target rate, further suggesting that currency intervention could be applied to stop the loonie’s rise

• Intervention by the Bank of Canada can be carried out almost without limit since there are no operational constraints on printing domestic currency and buying up U.S. currency and government bonds (China has been doing this for years); this would definitely be a possibility should the economy begin to wilt under the weight of the loonie’s rise

Time to wake up Canadian investors and do some foreign diversification. Shake off the cobwebs of inertia and go shopping for U.S. assets with your much enhanced purchasing power! 

But the $64,000 question is (in U.S. dollars, of course): which U.S. assets to buy? 

Stocks are a bit scary at the moment because they have run up so far so fast. Halloween might be more trick than treat this year murmur the goblins — one being Gluskin Sheff strategist David Rosenberg. He has the DNA of a bear but we still might want to take note of his point that stocks typically haven’t gone up by this much until the second or third year of the business upturn.  

Still, there may be some pockets of undervaluation in the U.S. stock market. It might take awhile, but I can see the SPDR S&P Homebuilders ETF (XHB) being much higher. The U.S. housing market was ground zero and still looks like it. There remains a big wall of worry to scale and a lot more recovering to do.

U.S. stocks in health care, technology, consumer products and other areas underrepresented on the Toronto Stock Exchange, can add diversification to a portfolio of Canadian stocks. A recent John Heinzl article mentioned some picks in this regard. We could add some ETFs such as the PowerShares Dynamic Pharmaceuticals (PJP) and iShares Dow Jones U.S. Healthcare Providers (IHF) funds. They are in health sectors that should emerge as winners once the overhaul of the U.S. healthcare system is complete, according to Reuters.

Bonds might not be such a steal anymore either but with stocks having run up so much and now likely exceeding chosen allocations in portfolios everywhere, it might be more prudent to go with bonds at this stage. Indeed, the year-end rebalancing is coming up for many investors and allocating toward bonds will be the path they have to go if they are to stay disciplined. And, of course, if you are near retirement or have trips/sojourns planned in the U.S., fixed-interest investments are the way to go.

High-yield bond ETFs are still offering yields in the vicinity of 10%. Examples are SPDR Barclays Capital High Yield Bond (JNK) and iBoxx $ High Yield Corporate Bond Fund (HYG). High-yield bond ETFs are not available in Canada, so they would be a welcome addition for investors reaching for more yield in their fixed-income allocations.

Many other, more conservative, bond ETFs are available. The ones tracking short-term bonds, such as the Vanguard Short-Term Bond ETF (BVS), are less exposed to capital loss and their interest rates will move up more quickly if market rates rise. A U.S.-dollar savings account has no price fluctuations to worry about; rates are low (ING Direct pays 0.75%) but should move up as the economy recovers.

Some other ideas for buying U.S. assets that I have posted on before: 

- Probably the cheapest of U.S. assets to buy right now is real property — unlike other assets, prices still haven’t gone up much (although the work involved in carrying out a transaction is onerous) 

- Another idea is to buy Canadian assets in line to benefit from the soaring loonie, such as shares in Canada’s largest travel-tour operator, Transat A.T. The high loonie means it’s more affordable for Canadians to visit and/or stay in the U.S., which plays to Transat core business of arranging foreign travel and accommodations.

A final note: the loonie could even go past the peak of $1.10 (U.S.) attained in 2007, say some forecasters. Spacing of asset purchases over time would average out the timing risk.

In 2007, when the loonie went above parity to the U.S. dollar, Transat’s stock traded as high as $40, and never was less than $30. Today, as the loonie climbs to within hailing distance of parity, Transat’s stock price is near $13.

The travel industry has been hit hard by consumers cutting back on vacation spending during the recession. Moreover, the industry has been wrestling with an overcapacity problem that has spawned a price war.

Analysts say Transat is large enough to withstand the vicissitudes. It may not happen overnight but economic recovery will eventually boost consumer income, while exits from the industry by weaker rivals will trim capacity and leave more of the market for the remaining companies. And Transat has undertaken corporate restructurings that have lowered its costs.

Also, according to a recent report by RBC Capital Markets analyst Tanya Messinger, Transat has a:

• strong balance sheet and over $200-million of unrestricted cash, and
• high forecasted free-cash flow generation (which will allow it to quickly pay down debt)

Near term, however, there could be a bit of turbulence. Ms. Messinger notes competitors are still adding capacity. And swine flu may again rear its head.

First, diversifying into foreign markets is less appealing because the Canadian dollar has now lost a great deal of purchasing power and buys much less (hopefully you did your foreign diversification as 2007 came to an end). As well, the risk of incurring currency losses on foreign holdings has risen since the loonie has fallen back closer to the bottom of its historical range and is more likely to go up in years ahead. In short, it’s perhaps time to think about investing more in Canadian stocks.

Second, the drop in the Canadian dollar obviously benefits manufacturing and other non-resource exporters that have long suffered under the loonie’s rise over recent years. This sector of the Canadian economy perhaps deserves more attention, especially if the exporter has a lot of clients in recession-resistant sectors. An example might be SNC-Lavalin Group (SNC.TO), which takes on infrastructure projects for governments around the world.

Third, the drop in the loonie means the dampening effect of a strong currency is gone. Imported inflation will put pressure on the Canadian consumer price index to rise and that means the Bank of Canada will have less leeway to lower interest rates in response to recessionary conditions. Shares in Canadian companies selling mainly to the domestic market may reward investors less than companies selling more to foreign markets.