A tool used by some investors and advisors to fine tuneforeign diversification in their portfolios is purchasing power parities (PPPs). They are, from one perspective,exchange rates that equate the cost of a basket of goods in one country to the same basket in another country.
The OECD calculates PPPs annually by taking the ratio of domestic prices forgoods in two or morecountries. For example, for Item X in the U.S. and Canada, they would form the ratio $1.75 (U.S.)/$2.00 (CAD) to get a PPP of $0.85 U.S./CAD for the item.
In 2009, when the OECD did this for the whole basket of goods, they estimated the PPP between Canada and the U.S. to be $0.8382 U.S./CAD.
As the current exchange rate of $0.97 U.S./CAD is about 15% higher than the PPP, there is an incentive for Canadians to shift their spending toward U.S. goods since prices are generally 15% cheaper to Canadians after currency conversion. Similarly, U.S. citizens have less incentive to buy Canadian goods.
The more the loonie rises above the PPP, the greater the pressureon the loonie to reverse course and fall back toward the PPP. Thats because Canadians will be increasingly exchangingtheir loonies for U.S. dollars while Americans will increasingly be demanding fewer Canadian dollars.
This is why I tend to favourgreater unhedged exposure to U.S. assets when the loonie nears or goes above $1.00 U.S./CAD. The U.S. dollar is getting close to the point when it is likely to begin appreciating against the loonie –and thus create additional gains on U.S. holdings in Canadian portfolios. Conversely, when the loonie is 10% to 15% below PPP, I would consider more hedging of the currency risk.
PWL Capital Management Inc., an investment counseling firm specializing in ETFs, is favourably disposed as well. In their blog, they say that substantial overvaluation in the loonie against the PPP would imply that even for an investor who takes the hedge-of-least-regret approach (i.e. 50% foreign currency hedging and 50% foreign currency exposure), there may be a benefit to tilting their U.S. portfolio holdings towards a higher exposure to the U.S. currency.