When it comes to stock investing, it’s usually prudent not to be overly patriotic. No doubt we Canadians have our fair share of great companies, but there is a world of investment opportunities out there. It would seem most tend to agree, because ever since our government relaxed the restrictions on owning foreign investments back in 2005, Canadian investors have been plowing dollars into international markets—most notably into the largest economy in the world, our neighbors to the south. Frankly, it makes sense. Compared to the United States, Canada has a very narrow market, meaning the value of our stock markets is predominantly made up of companies in just a few sectors of the economy, such as energy, resources and financials. This lack of market breadth can make diversification difficult. Combine this with the idea of investing in dynamic international companies, and international investing seems like a logical and attractive proposition.

Given these points, I think it will be of interest to look back and see whether Canadian investors have been rewarded for investing in opportunities south of the border. Although this review should be interesting, what may be most useful is to interpret some of the current factors that may play key roles in determining the future prospects for investing returns within the United States and Canada, going forward.

So, how has it worked out for Canadian investors since our foreign content rules were relaxed? In a word, terribly. On a pure return basis, the Canadian stock market (represented by the S&P/TSX composite) has outpaced the U.S. stock market (represented by the S&P 500) each year since 2005. In fact, the Canadian market has performed better in nine out of the past 10 years. This has translated into an annualized 10-year return for the Canadian market at 5.35% while the annualized 10-year return for the American market is negative at -1.38%. Unfortunately, the pain does not end there.

When a Canadian investor puts their capital to work in a foreign country, they must calculate the returns taking the exchange rate into account. Looking at it this way, the return to Canadians has eroded even further because of the weakening value of the U.S. dollar over the past seven years. Taking this currency movement into account, the 10-year annualized return of American stocks is an uninspiring -3.51%. To put this in context, a $10,000 Canadian investment in the S&P500 in January of 1999 would be worth approximately $6,995.57 a full decade later. That same $10,000 invested in Canada would be worth $16,840.13.
Clearly, it has been a punishing experience for most Canadians with U.S. investments—an experience that would seem destined to revert and change course, if for no better reason than the perceived odds of it. For an objective idea, however, it is crucial to examine the key fac­tors that drive economic growth (and hence, stock returns), as well as the value of a nations currency (reflected by an exchange rate).

So let us look first at exchange rates. In a floating rate system like ours, interest rates over the long term are a reflection of market participant’s beliefs about the fiscal and monetary health of a given country. Some key indicators of a nation’s fiscal and monetary health are rates of inflation, interest rate levels, as well as the amount of outstanding sovereign debt. When these factors are evaluated in the context of the Canada-U.S. dynamic, it is clear there are tremendous headwindsfacing the U.S. both right now and in the future.

Although an analysis like this would have proved more difficult a couple of short years ago, there have been tremendous actions taken—due to the current financial situation—that make this evaluation much clearer now. Let’s begin with a recap of some of the boldest actions taken so far to fight the current financial crisis. Incredibly, in a period of just over a year, the U.S. authorities have doubled their country’s money supply, lowered interest rates to generational lows, and issued an unprecedented amount of debt in order to pay for a trillion-dollar budget and various stimulus spending efforts. Although these efforts may have softened the blow of the crisis, they all have future consequences that can affect the long-term health and competitiveness of an economy. An increase in the money supply is, for many, the definition of inflation. While a certain level of inflation is acceptable, higher levels reduce the purchasing power of currency and lower standards of living. Low interest rates, while helping domestic growth by making credit cheaper, discourage savings and prompt international investors to seek out higher rates elsewhere. Together, these factors have the tendency of lowering the appeal of a nation’s currency and hence the value of that currency compared to others. The fact that Canada has not had to take such extreme measures makes a strong case for continued depreciation of the U.S. dollar, in terms of the Loonie over time.

When examining the second dynamic of this inquiry, the potential for future U.S. stock returns, the massive increase in government debt by the United States may provide a key insight into future expectations. This link may not be initially apparent, but it is important to understand the long term effects of debt issuance on the ability of an economy to promote growth. Although the funds raised by issuing the debt have been used to stimulate and increase the size of the current economy, the present growth that this spending affords must come at the cost of future consumption. Debts must be repaid with interest and there is really only one way for governments to do this: taxes. Given the record levels of recent debt issuance, higher levels of future taxation will certainly be required to repay these massive debts. As any business owner or employed individual knows, higher taxes undermine the ability for businesses to grow and for people to spend. This, again, points to a competitive advantage for the Canadian economy.

While the extraordinary actions of the U.S. authorities may have saved the financial system from a collapse, it is difficult to envision a path where these actions do not come with a future price tag, in terms of economic growth and currency value. We are also beginning to hear rumblings of a second U.S. stimulus plan and further money supply expansion, all of which will exacerbate the costs to future growth.

Although the focus here has been on how current actions being taken in the U.S. will have future effects on the broader economy, it is important to bear in mind that individual companies determine their own fortunes to a great extent. For this reason, investors cannot conclude that there are no merits to foreign investment. Diversification away from the narrow Canadian economy is just one other example of reasons to invest abroad and is one that investors should seriously consider. Nonetheless, when examining the comparatively attractive long-term prospects for the Canadian economy and our currency, there certainly can be made a case for Canada.

Sean Weaser is a Principal and Analyst at Integra Capital and can be reached at sweaser@integra.com.