A slowing u.s. economy and softening prices for resources is taking the shine off Canadian stock markets. And even though Canada has experienced four years of extremely good returns, many of the global managers and strategists surveyed by Investment Executive recommend diversifying assets outside of Canada in 2007. This year, they say, is the year to go global.

Not only do they expect a downturn in domestic markets, but some also foresee a lower loonie — which would enhance returns on foreign equities — and a narrowing Canada/U.S. interest rate differential, increasing the attractiveness of U.S. fixed-income.

Furthermore, four years of great Canadian equity returns may have left client portfolios overweighted in both Canadian and resources exposure. Canada accounts for less than 4% of world market capitalization; resources, such as energy and basic materials, account for a whopping 41.8% of the S&P/TSX composite index, vs 15.4% for the S&P global 1200 index.

In short, it’s an excellent time to take some profits and use them to rebalance portfolios and increase foreign exposure. Even managers of Canadian equity funds are going global, with companies such as Mackenzie Financial Corp. in Toronto increasing the allowable foreign content in their Canadian equity funds (see page 14).

And there is no point putting off selling in hopes of further gains. Timing the market is very difficult, and you could miss the boat. “You will never become poor by taking profits too early,” says Clement Gignac, chief economist and strategist at National Bank Financial Ltd. in Montreal. He also notes that clients are five years older than they were when the domestic boom started in 2002. He suggests that now may be time to reduce risk by increasing geographical and sector diversification.

Others strategists and managers agree, but with some caveats. Leo de Bever, chief investment officer at Victorian Funds Management Corp. in Australia, warns advisors to be careful of markets that have been running a while. And, he says, corporate governance may not be as good in some markets as it is in Canada: “It’s easier to monitor, and there’s a lower cost to getting in and out of Canadian investments.”

Fred Sturm, Mackenzie’s chief investment officer, also emphasizes the monitoring risk and urges the use of professional managers. “You can get blindsided by risks you weren’t tracking,” he says.

Jean-Guy Desjardins, president of Fiera YMG Capital Inc. in Montreal, advises keeping a close eye on currencies. The Canadian dollar is expected to decline against the U.S. greenback this year, but it is likely to be under more upward pressure than downward over the next five years, assuming there’s no recession. The C$ is a petrocurrency that tends to go up and down with oil prices — and oil prices are expected to remain high.

Despite the suggestions to go global, Desjardins believes there is little to be gained by individual investors going global in fixed-income. With equities, investors capture capital appreciation as good companies increase their earnings. But with bonds, they get a fixed interest rate and, as a result, are more exposed to currency risk.

David Wolf, head of Canadian economics and chief strategist at Merrill Lynch Canada Inc. , disagrees, pointing out that U.S. interest rates are expected to drop more than Canadian rates. That would make U.S. fixed-income more attractive than it has recently been. If the C$ also drops against the US$ — he expects the C$ to be heading to US80¢ by the third quarter of this year — U.S. bonds could be a good buy.

Still, at Richardson Partners Financial Ltd. in Winnipeg, Clancy Ethans, chief investment officer, echoes the warning about the currency risk: “You need to invest to match future liabilities with assets. How well they match in terms of currency should determine how much currency exposure you have.”

Advisors need look back no further than the past few years to see the toll an appreciating loonie can take on returns. The C$ rose 35% against the US$ in the three years ended Dec. 31, 2005. Once portfolio returns were translated into C$, that sliced 35% off whatever gains clients had made on U.S. equities.

But you don’t need to stay at home to avoid currency exposure: you can hedge that exposure back into C$. That’s what de Bever recommends for U.S. investments this year.

@page_break@Although economists are divided about where the C$ is going in 2007 (see page B15), there’s more unanimity when it comes to other currencies. With only a few exceptions, most economists believe the US$ will go down 5%-10% against the euro and yen. That means that even if the C$ rises vis-à-vis the greenback, it probably won’t rise vs the other two currencies. And if the loonie remains stable or falls vs the US$, it will drop as much or even more than the US$ will against the euro and yen, providing additional returns for European and Japanese investments when translated into C$.

As a result, no one is suggesting hedging European or Japanese investments back into C$. Indeed, quite a few global managers and strategists suggest, at the very least, overweighting European exposure because the expected currency moves will enhance returns. Only some analysts suggest overweighting Japan because they are convinced that market will perform relatively well this year.

With Canada accounting for less than 4% of global market capitalization, sticking to Canadian companies severely limits investors’ options and makes it unlikely that they will be invested in the best companies in many sectors.

Even among Canadian resources companies, many of which are major global players, there are firms elsewhere that may be better bets. Forest products is a good example. Brazilian pulp and paper producers are far more competitive and profitable than Canadian firms. Furthermore, consolidation is reducing the number of Canadian companies in some subsectors. For example, in nickel, both Inco Ltd. and Falconbridge Ltd. have been bought by major global players.

In some sectors, sticking with Canadian companies is even more of a problem. The Toronto Stock Exchange has a mere 0.8% weighting in health care, vs 9% for the S&P 1200. There are not many Canadian pharmaceutical companies from which to choose.

The only sector other than resources for which the TSX has a substantially heavier weighting than the S&P 1200 is financial services, at 33.4% vs 27%. And, as with resources, advisors may still want to have some global companies in clients’ portfolios. This is especially the case right now because Canadian bank stocks are trading at a premium compared with their global competitors, having been bid up as interest in Canadian equities blossomed with the resources boom.

None of the money managers and strategists surveyed are suggesting that investors shrink their Canadian weightings to match the S&P 1200 index. We live in Canada, our income requirements are in C$ and we are familiar with and can closely follow Canadian companies. Investors could go as high as 50% in foreign content, but 33% would provide good diversification.

The sector mix is more difficult. Given the strong outlook for energy and metals prices over the medium term, a weighting between the S&P/TSX index and the S&P 1200 would be appropriate. For example, 15% energy and 10% basic materials.

There’s less of an argument for going beyond the S&P 1200’s 27% weighting in financial services. But it wouldn’t be unreasonable, given the general stability of Canada’s big banks and life insurance companies. Going outside Canada for some of these holdings is not a bad idea, but, again, sticking with Canada would be reasonable.

There are plenty of Canadian telecoms and utilities, although, even in this sector, there may be better bets globally.

It’s when advisors get to industrials, consumer staples, consumer discretionary, health care and information technology that going global makes sense for at least some holdings. IE