National Bank Financial cautions investors from anticipating that the strong loonie also signals strong stock market returns. In fact, the loonie’s rise is likely to pressure corporate margins, it warns.

“The Canadian equity rally that started in 2002 was in large part fuelled by an unprecedented increase in commodity prices. As Canadian resources attracted more interest from investors, demand grew for the Canadian dollar,” NBF says.

“It is worth noting that the impact of the rising currency on resource companies’ earnings was completely offset by the commodity price appreciation. Since the beginning of 2002, the loonie appreciated nearly 50% versus the greenback. But during this period, the CRB index more than doubled (+109%),” it adds.

“This time around, however, the loonie’s appreciation is not accompanied by a commodity prices rally (but rather an expectation of an upcoming divergence in CAN-US monetary policy). As a result, we fear that the ongoing profit margin squeeze observed over the past few years in the manufacturing sector could spill over to the entire resources sectors if commodity prices do not catch up soon with the Canadian dollar,” NBF warns. “Indeed, resource companies, which sell commodities in U.S. dollars, would consequently take in fewer Canadian dollars while paying the same salaries, benefits and other input costs in Canadian dollars.”

“Investors should be careful not to extrapolate that the Canadian dollar appreciation will continue to push the S&P/TSX index higher. With many sell-side analysts still assuming a dollar between 85¢ to 90¢ for 2007 and 2008, be ready for significant downward earnings revisions if the dollar reaches parity as have we predicted since May 2006 due a CAN-US interest rates convergence,” it concludes.