It would appear the bark was worse than the bite. After months and months of tough talk, name calling and threats of walking away from any trade deal, the US and Canada (plus Mexico) have agreed to a new NAFTA deal called the United States-Mexico-Canada Agreement (USMCA). We would say this resolution is a positive surprise for Canada. Yes, concessions were given on the dairy front, opening up more of our market to the US, but most other key friction points went our way.
The USMCA is set to last for 16 years, which is a good thing. That helps remove uncertainty and allow businesses to make longer-term decision. Canada won again on keeping the dispute-settlement mechanism. The new terms on autos and auto parts appear largely positive for Canada. Online shoppers should welcome the move to allow purchases below $150 to be duty-free, which may hurt some Canadian retailers. As mentioned, the biggest concession is allowing access to 3.5% of Canada’s dairy market, slightly higher than the 3.25% Trans-Pacific Partnership level. Perhaps the price of cheese will fall, but the government plans to compensate dairy farmers, so higher taxes may offset the consumer gain.
There was much speculation that the hardline talk taken by the US was largely politically motivated. Lots of tough talk sound bites for politicians ahead of the mid-term elections and a win in the form of a better deal ahead of going to the polls. We would expect this new deal to be marketed as a win by US congress members vying for re-election.
This is good news for the Canadian economy. A big, harsh overhang has been removed. While it had a low probability of occurrence, it would certainly have caused a big economic hit if talks failed. We would not be surprised to see the consensus of 2.0% GDP growth for next year to move marginally higher.
This deal also makes rate hikes by the Bank of Canada more likely. In its latest statement, the BoC specifically highlighted trade uncertainty as a contributing factor to its decisions. Now with this removed, it is more about the economic data and the data has been good.
This bring us to the loonie. The trade deal obviously removes a big overhang from the loonie and there was a move higher. However, this move has not impressed most and we were left wondering, can it get any better for the loonie?
C$: where to from here
One would have thought that given the strong Canadian economic GDP print on September 28, oil trading into the mid $70s, the good news of a multi-billion dollar investment into LNG capacity and the USMCA deal, the loonie would have rallied more. The C$ strengthened by 1% on Friday, thanks to the economic data and 0.73% on Monday with all the other good news. But since then, it has given back about half those gains with the market moving into more of a risk-off environment.
This brings us to the economic data. The US data has been failing to impress expectations since the beginning of the year, as made evident in the declining orange line in the chart to the right. The orange line is the Citigroup Economic Surprise Index for the US. The blue line shows the same for Canada. We would note the C$ failed to rally much when the Canadian data was surprising to the upside. However, now the US data appears to be turning more positive. This has been a seasonal trend evident over the past seven years that has seen soft US data in the first half of the year and stronger data in the back half. Meanwhile, Canada appears to be starting to soften. The recent employment data from Canada was very strong, but the vast majority of new jobs were part-time, with the full-time category actually shedding jobs.
If these trends reverse course and we transition to a market with better US data and softer Canadian reports, we would bet the C$ would soften.
Care for some more support that the C$ should weaken? Yield spreads, based on 2-year maturities, certainly favour a lower C$ relative to the US. Yields in the US continue to be much more attractive than in Canada, plus they appear to have inflation and an economy firing on more cylinders than ours. Risk-on currencies, which include the C$ and Australian dollar (AUD), usually trade together. But, they have not recently, as the AUD has been declining while ours has held up. While we could argue the AUD is more levered to China, which is in a bear market and its housing industry appears to be in some trouble, if this relationship reasserts, there is an air pocket under the C$.
There is also an air pocket under the C$ if you look at emerging market currencies. Now, we are not saying the C$ is an emerging market currency, but there has been a long, strong relationship over the years and currently there is a big divergence.
There are some counterarguments to a weaker C$. Oil in the mid $70s is certainly a strong one. Plus, from a valuation perspective, the C$ is about 5% undervalued vs. the US$. US$ may also be starting to top out as global yields rise, playing some catch up to the US. Still, when a big pile of bullish C$ news hits and the result is tepid, the market is telling you something. Likely the path of least resistance for the C$ may be to the downside for now.
— Craig Basinger, Chris Kerlow, Derek Benedet and Shane Obata are members of Richardson GMP’s Connected Wealth team which manages Purpose Core Equity Income Fund, Purpose Tactical Asset Allocation Fund and Purpose Behavioural Opportunities Fund