Canadas Jekyll and Hyde economy

Canadian manufacturing vs. Canadian resource companies, and why it might be time to get back into manufacturing
Investing is hard, but to compound the problem, the Canadian investor faces an extra dilemma: we have a Jekyll and Hyde economy. This stems from the fact that Canada has an outsized resource sector as well as a large manufacturing sector, combined with a floating exchange rate that bobs around with resource prices. The resulting tendency is for a strong resource sector to be accompanied by a weak manufacturing sector, and a weakening resource sector to go along with a strengthening manufacturing sector. There is no universe in which both do remarkably well. Canadian investors need to be aware of the Canadian economys Jekyll and Hyde nature in determining the makeup of their investment portfolios. In general, the Canadian economy has outperformed most national economies over the last decade and, as a result, the average Canadian household is wealthier on a relative basis than we once were. This general outperformance is no doubt due to rising resource prices, which help not only the oil, gas, and mining sectors, but have spill-over effects that permeate the entire Canadian capital structure. Rich drillers in Fort McMurray and loaded miners in Timmins mean prosperous donut shop owners, and prosperous donut shop owners mean healthy bankers. You get the point. Because we are significant exporters of resources, and the prices of these tend to be volatile, resource prices have a tremendous influence on Canadas terms of trade. This latter refers to the ratio of Canadas export prices to import prices. The terms of trade, which have moved dramatically in our favour since 2000, have encouraged the upward movement of the Canadian dollar. (See chart 1) After all, the more expensive that Canadian stuff is for foreigners to buy, the more loonies they need to purchase in order to own that stuff, and this pressures the loonie higher. In addition to higher commodity prices, the surge in hot money flowing into Canadian capital markets helps push the C-dollar higher (see Hot Money, Cold Country.) One of the innocent bystanders amongst all this cheer has been the Canadian manufacturing sector. Energy inputs are a significant part of manufacturing costs, biting into their bottom line. More importantly, the resource-inspired rise in the Canadian dollar means that the prices of manufactured goods for sale in Canada tend to become more expensive relative to those same goods manufactured overseas. Local wages, which must be paid in Canadian dollars, are slow to adjust downwards and, as a result, manufacturing margins are pummeled. It doesnt help that other countries with much cheaper labour are competing in the same manufacturing arena and able to offer better prices. In chart 2, we show manufacturing returns on capital relative to average Canadian returns. In general, manufacturing outpaced most sectors through the 1990s. This was a manufacturing golden age characterized by weak resource prices and a falling loonie. Things changed dramatically in the early 2000s as the resource/c-dollar boom kicked off in earnest. This inversion, of course, illustrates the Jekyll and Hyde dilemma facing Canadian investors. Prosperity in resources cannibalizes manufacturing. We have constructed a Canadian manufacturing equity index which is comprised of Bombardier, CAE, and twenty other manufacturers who have been publically traded since 1994. To qualify for inclusion, all companies had to have a significant

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number of their facilities in Canada. This index (see chart 3) has remained mired below 2002 levels. Chart 4 shows the ratio of our manufacturing index to an index of 50 non-manufacturing equities, also publically traded since 1994. In general, investing in manufacturers outperformed through the 1990s up till around 2002. From then onward they were a losing proposition and nonmanufacturers, in particular resources, became the game of choice. The ratio bottomed out in 2009, although weakness in 2011 among manufacturers leaves one wondering if they have indeed turned a corner.1 Here is the case for why Canadian manufacturing stocks, having played the dastardly Mr. Hyde for the last decade, might turn back into the more affable Dr Jekyll: A. The necessity of adapting to a continuously rising Canadian dollar means that Canadian manufacturers have probably never been as efficient as they are now. This is the opposite of 2001 or so when, having grown fat and lethargic thanks to

the benefits of a constantly falling loony, inefficient Canadian manufacturers were blindsided by the that currencys reversal. B. While Chinese manufacturers will continue to take away low margin business, particularly in non-durables, Canadian manufacturers enjoy an advantage in the realm of complex manufacturing processes requiring large investments in human capital like education. C. With the glut of natural gas coursing through North America, and what seems to be a massive oil boom on its way (see The Blue Eyed Sheiks are Back) , energy prices will probably not have the same buoyancy they did during the last decade. As a result our terms of trade should soften, ensuring the C-dollars buoyancy is pricked. For those manufacturers left standing after a ten year manufacturing recession, a weaker dollar would be a godsend.

1. For the curious, here is an explanation of how we built our indexes. For the manufacturing index, we used monthly price data for all manufacturing stocks trading on the Toronto Stock Exchange in 1994 and 1995 that currently to trade on the exchange. For our non-manufacturing index, we randomly chose 50 TSX listed non-manufacturers in 1994 who continue to trade on the TSX. Regardless of their market capitalizations, we set each stocks initial trading value equal to $1. The final value of either index is the median price of all component stocks. Median values rather than averages avoid outliers that skewed the final results.

John Paul Koning jpkoning@pollitt.com

Toronto, Ontario February 14, 2012

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