With so much uncertainty out there, experts point out where investors can look for guidance
The Canadian economy looks suddenly unsteady, despite strong Q2 GDP growth, because of a torn-up trade deal with our only neighbouring country. Rhetoric has ratcheted up, with the US President declaring a new name for Lake Ontario and the Premier of the eponymous province telling that President to “kiss my a**.” Given how extreme the rhetoric has appeared, and how high the stakes really are, investors might look at the relatively muted reaction on markets and scratch their heads. While the old mantra of ‘the Canadian economy is not the Canadian stock market’ can explain the strength in equities since trade talks broke down, fixed income and currency markets ought to be more challenged. Somehow, though, they’ve held in.
After an initial shock reaction in Canadian bonds, which fell eight to nine basis points, Derek Johnson and Rohan Thiru say the Canadian bond market has largely looked through the ongoing trade war. Johnson and Thiru are VPs and Portfolio Managers at Canoe Financial, where they manage the firm’s core fixed income strategies. They explained how an as-yet unresolved balance of uncertainties about tariff impacts have kept bond markets on something of a hold.
“One of the possibilities is that the market is expecting a resolution. Tariffs are universally bad for both the US and Canada, and that creates a great incentive for the adults to get back in the room,” Johnson says. “The problem with this is that there are no adults to get back in the room. It seems like it’s all kids fighting right now, bringing up what Lake Ontario should be renamed to. But, at the end of the day, there is a mutual interest in resolving this, because tariffs are stagflationary and stagflation is not good for anybody.”
Assessing which side of tariff stagflation hits harder
Johnson says the key unresolved issue for bond markets is in whether US tariffs and Canadian retaliatory tariffs put more downside pressure on GDP growth or upside pressure on inflation. Johnson adds that the $7.5 billion aid package announced by Prime Minister Carney could also be an inflation accelerator.
If the economic devastation wrought by these tariffs is significant enough, then Johnson and Thiru see the Bank of Canada as likely being forced to reduce interest rates. However, if inflation rises significantly, then the BoC may be forced to hold rates or even hike to try and calm inflation down. Johnson and Thiru note that tariffs represent a supply shock, which monetary policy has less influence over. The BoC, as Johnson puts it, may be “stuck between a rock and a hard place.”
How currency markets reflect the same dilemma
Mirza Shaheryar Baig, Global FX Strategist at Desjardins, says that the same uncertainty around impacts on inflation and growth have kept the value of the Canadian dollar relatively stable, despite the currency’s tendency to reflect economic prospects. Baig argues that markets may be a bit fatigued by tariffs and prefer to look through the rhetoric, viewing many of the current stances as just negotiating tactics. Currency markets are therefore less likely to make knee-jerk reactions to trade news.
When the new trade dynamics turn permanent, however, Baig expects some kind of currency reaction.
“The relevance comes when it becomes permanent, when markets see that as a permanent change in the economic outlook. And especially if it shapes outcomes for employment loss and for inflation in Canada, and then ultimately impacts Bank of Canada's policy,” Baig says. “I think until we get to that point, I think the currency market is just not interested in trading the headlines anymore.”
Baig says that if the Bank of Canada decides that the impacts on unemployment and GDP growth are more severe than the pressure on inflation, they may cut rates and that would signal a drop in CAD. He notes, though, that the BoC has made no noise to that effect so far. He also notes, however, that the significant investments by the Federal government in realigning Canadian trade, ports, and infrastructure away from US-reliance, could be supportive for CAD and ultimately mean the Canadian dollar rises against the USD. Moreover, if the trade war means a revision in the favourable treatment of Canadian investors by US securities regulators, then some of the roughly $3 trillion Canadians currently invest in US assets could come back home, which Baig says would further support CAD.
Grappling with uncertainty
Baig, Johnson, and Thiru all emphasized just how uncertain things are at the moment, stressing how that uncertainty has markets reacting less than they otherwise might. Johnson and Thiru stress that so much of this uncertainty seems to be driven by a US administration that doesn’t really know what it wants. Thiru notes that for all the rhetoric about a trade deficit with Canada, excepting hydrocarbons and fertilizers the US actually has a trade surplus. However, none of the tariffs are impacting energy and fertilizers from Canada. Thiru and Johnson believe that there is more of a desire to simply ‘win a fight’ by the US administration here. The inherent ambiguity of that goal, however, makes predicting outcomes incredibly difficult.
What Johnson expects, however, is that the yield curve should steepen somewhat amid all this uncertainty. He expects the Bank of Canada to remain on hold while economic support comes from fiscal policy, which should result in more borrowing and more future inflation, causing that curve to steepen. Corporate credit, he adds, should be more reflective of stock market risk and the TSX’s relative insulation from trade risks should be supportive for credit. Overall, Johnson and Thiru are of the view that a steady hand is more likely to see clients through this mess.
“Overanalyzing this thing and trying to pivot the portfolio will drive you crazy,” Thiru says. “When you have a problem, there are certain things you can control, certain things you can't. The cards are going to fall where they fall and we just have to play them.”
“Keep calm, carry on,” Johnson adds.
