• David Cockfield & Arthur Salzer

A Deal At Last

Updated: May 3, 2020

After 14 months of intensive negotiation that was at times marked with threats and political posturing, a new trade deal with the U.S., Canada and Mexico was finally reached to replace NAFTA. The lack of an agreement and the long lasting and acrimonious negotiations were a cause of real concern in the corporate sector. Company managements saw the lack of an agreement as an added risk to long term investment decisions in expanding production facilities, adding new branches, or increasing their workforce. The removal of this uncertainty should give the Canadian economy a boost. The new agreement provides certainty in ensuring Canada benefits from the strong growth in the U.S.

The new U.S., Mexico and Canada trade pact (USMCA) replacing NAFTA can be viewed with mixed emotions. The inexperienced Canadian team who attempted to add social policies to a foreign trade negotiation caused us backlash and were almost frozen out of the deal as the U.S. and Mexico came to an agreement first. Canada was then forced to back step, which fortunately minimized damage, but we took some hits regardless. Parts of our protected and outdated dairy market, which operates under supply management, were opened to U.S. competition; benefiting Canadian consumers through lower food prices. Patent rules in the pharmaceutical area were changed to favour existing drug patents and discourage generic competition. Canada and Mexico were unable to have the tariffs on steel and aluminum removed. On the positive side Canada managed to dodge several very negative bullets in the U.S. proposals.The dispute resolution system (Chapter 19) was retained rather than replaced by a U.S.-biased proposal.The U.S. initial proposal for a sunset clause of only 5 years for the agreement was dropped and replaced by a 6 year option to make changes or to terminate the deal 10 years later. Corporate reaction to the 5 year proposal was universally negative as 5 years was not long enough to provide a basis for corporate capital spending plans.

The U.S. economy, stimulated by major tax cuts, regulatory changes and sustained energy production is experiencing a major growth surge. Unemployment is at an 18 year low. Average hourly earnings have reached a 9 year high and earnings are expected to be up 3% by year end. Consumer confidence is the highest in decades buoyed by rising disposable incomes. U.S. household debt is well below its peak prior to the financial collapse of 2008. Retail sales are strong and expected to grow by 3.5% in 2018. GDP growth in the U.S. is presently running close to 4% - well above recent levels. Coupled with stocks hitting all time highs U.S. consumers are confident in their ability to save and spend.

On the Canadian side, the Canadian economy has been surprisingly strong at 2%, which perhaps should not be surprising as strong U.S. growth has been positive for Canada in the past. Canada is not without problems, as our means of exporting our natural gas and oil is limited. The cost of these limitations is in the billions of dollars. Canadian Select, our heavy oil, is selling at a discount of C$50 per barrel to West Texas Oil due to a lack of transportation facilities, which are the result of extreme environmental activism and adverse Federal Government policies.

What is the state of financial markets? In the U.S. the Federal Open Market Committee (FOMC) increased the federal funds rate, which dictates the rate banks lend to each other. The move was fully anticipated by markets which expect a further rate increase in December of this year and further increases in 2019. It should be realized that interest rates are still at historical lows. Inflation is still in the acceptable 2% range and only recently began to show more upward tendencies. The combination of rising wages and tariff-generated price increases could well push inflation higher. Further rate increases by the Federal Reserve will put pressure on new housing sales and consumer debt. This will likely have a slowing effect on U.S. economic growth in the future.

In Canada, given slower growth and low inflation the Bank of Canada has not increased the bank rate. Recent GDP growth in the 2% range was higher than expected and encouraging in light of the uncertainties facing the Canadian economy because of the then ongoing NAFTA negotiations.

While fixed interest rates in the U.S. and Canada have drifted upwards over the past quarter, U.S. and Canadian equity markets have traced different paths. The S&P/TSX hit a high on July 12, 2018 of 16,561. Recently (Sept 28/18) the TSX traded at 16,073, a decline of 2.9%. In the same period the U.S. S&P 500 rose 4.6%. The underperformance of the TSX can be attributed to a combination of the threat of tariffs, poor NAFTA negotiations combined with the anti-business and energy policies of the federal government. With a successful agreement behind us, it would be reasonable to assume that this performance gap, to some degree, will be eliminated.

While equity markets in some sectors appear fully priced, earnings growth continues to be strong. As long as corporate earnings follow the present upward trends it is hard to see the present bull market ending. There are definitely concerns to consider; rising interest rates, a surge in inflation, an escalation of new tariffs into a full scale trade war, are only a few. At this time however there are no signs of an imminent recession. The economic momentum in the U.S. and Canada seems likely to continue well into 2019. So far this period of growth has shown only a few signs of the excesses that normally precede a recession. However 2020 should be watched closely and may well be the year of retrenchment.

Our strategy in the fixed income asset class has been focused on avoiding exposure to long-term fixed income investments while favouring opportunities that focus on the “real economy” rather than the “financial economy”. The areas where we see the greatest return versus risk are in the areas of supplying growth capital for companies (private debt), hard asset lending (private mortgages) and critical infrastructure.

In the equity portion of portfolios we have recently reduced exposure in our ETFs to the low volatility sector in order to emphasize greater exposure to broader markets including emerging markets. For investors with long-term horizons and a limited need for liquidity, private equity (both in the growth equity and secondary sectors) has the potential to create value in excess of the public markets over time.

As a complement to fixed income and equity asset classes, we view multi-family real estate as having good potential as strong rent growth should compensate for higher interest rates.


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