If investors are concerned about Canada’s competitiveness in the face of U.S. fiscal stimulus and tax reform—as well as trade protectionism—they’re in good company.
The Bank of Canada noted in its April monetary policy report that U.S. GDP growth, and weaker investment and exports are among risks to its inflation outlook.
In a weekly financial digest, BMO chief economist Douglas Porter comments on Canada’s competitiveness, saying, “Almost from the moment that U.S. tax reforms were approved late last year, concerns over Canada’s ability to attract capital and talent were raised, compounded by the lingering uncertainty over the fate of NAFTA.”
He notes that foreign direct investment experienced a record net outflow last year of almost $70 billion. And “domestic business investment remains soggy, as total non-residential capital spending was just 11.4% of nominal GDP by the end of last year, compared with a U.S. reading of 12.7%,” he says.
Canada’s slowly growing productive capacity raises doubt about the country’s medium-term growth potential.
“One way in which that lack of productive capacity is showing up in real time is the renewed deterioration in Canada’s merchandise trade flows,” says Porter. The trade deficit “hit a record $4.1 billion in March, taking the 12-month tally to over $30 billion (or 1.5% of GDP) from barely $20 billion a year ago.” The deterioration comes despite a competitive loonie and recovered oil prices, he adds.
Specifically, Canadian merchandise export volumes have risen only 0.4% over the past year. That performance is no one-off: “In each of the past two years, export volumes rose by a paltry 1.0%,” says Porter. “Meantime, imports are on wheels, surging 9.1% [year over year] in March.”
Canada, like the U.S., has a significant trade imbalance with China. The country’s deficit with China jumped to $2.2 billion in March, as Chinese imports to Canada soared 25.6% year over year. “That lifts the 12-month cumulative imbalance to a record gap of $19.5 billion, alone accounting for almost two-thirds of Canada’s overall deficit,” says Porter.
Though exports to China may have been constrained in recent months by rail bottlenecks, Porter says the underlying deterioration in the trade imbalance has been “mostly relentless” for the past five years.
Despite this data, Porter says his growth outlook so far hasn’t changed.
“We were already expecting a meaningful drag from net exports in Q1, and this may now extend into Q2,” he says. “And the fact that the latest deterioration is mostly driven by a […] spike in imports suggests that domestic demand is still doing fine.” He calls for 1.5% growth in Q1 and 2.0% for the year.
In a trade report, Derek Holt, vice-president and head of capital markets economics at Scotiabank, notes that, month over month, export volumes were up by 3.0%, the strongest rise since July 2016.
“The trend has been volatile and marked by many fits and starts, so fill the champagne glass only halfway, but at the margin these figures suggest that a soft patch across earlier months may be giving way to a better picture,” says Holt.
Holt expects better export figures on the back of forecast U.S. growth, which will be aided by fiscal stimulus. “Buy America or not, some of that will most likely leak out by way of demand for Canadian exports,” he says.
Porter remains concerned about competitiveness, however. “The longer-term issue is the groaning trade gap even at a time of booming global growth, a competitive loonie and solid commodity prices,” he says. “When these benign conditions change—as they so inevitably will at some point—Canada’s competitiveness challenge may be truly exposed.”
How to invest during tough times for trade
Protectionist trade measures have been on the mind of Talbot Babineau, president and CEO of IBV Capital in Toronto. In a first-quarter letter to investors, he takes a closer look at the current trade spat between the U.S. and China, as well as the 1930s protectionist era in the U.S., when the Smoot-Hawley Tariff Act was enacted.
He shows how the effect of current U.S. protectionist trade measures aren’t nearly as severe compared to those in the 1930s. While imports are a greater proportion of GDP today, the steady enactment of free trade agreements since the Great Depression era have diminished the impact of custom duties—to only 1.3% of imports, says Babineau, compared to more than 10% of imports in 1929. “We’re far from the most protectionist extremes in United States history,” he says.
However, he notes that, relative to the U.S., some developing countries, like China, have maintained unfair trade practices to grow their economies.
“Until now, the United States and others left these unfair trade barriers largely unchecked—and rightly so,” says Babineau. “The goal was (and should be) to grow the size of the global economic pie instead of just taking a larger slice of it.”
The concern, however, is that, at its current growth rate, the Chinese economy will surpass that of the U.S. in less than 11 years, says Babineau. “This suggests to us that there is limited time before America’s economic negotiating leverage is greatly diminished, which will leave China in position to manage their economy completely unencumbered by long-standing global trade rules.”
Though tough tariff talk has resulted in more volatile markets, the threat of a trade war may eventually lead to improved globalization, as China is brought to the negotiating table, says Babineau.
Thus, instead of viewing resulting volatility as a risk, he views it as an opportunity. For example, over the last few years, he’s explored investing opportunities that were interesting but not attractively valued enough to buy. Now, with increased volatility “we have found ourselves to be very active buyers of these opportunities,” he says.
The common characteristic of these buying opportunities is they contain embedded catalysts, such as “turnarounds, spin-offs, aggressive share repurchases and hidden contractual obligations,” says Babineau. These will unlock value in the coming years, he says, adding that returns will likely be idiosyncratic as opposed to market-driven—and that’s a good thing. “Considering market valuation multiples are at historically elevated levels, this will become a valuable and important return characteristic for us.”
The recent multiples expansion will make passive returns increasingly difficult to realize, he says. Instead, generating returns “will require relentless sleuthing to find new ideas, deep due diligence to uncover value, and in some instances active involvement to realize an investment’s full potential.”
Babineau strategically builds his cash position to invest in undervalued securities, which results in the portfolio experiencing more pronounced changes in daily market value.
“Year to date, we’ve seen an increase in the intrinsic value of our portfolio, and the market value of our portfolio has declined,” he says. In fact, the gap between intrinsic and market value widened to almost 56%, he says. “Naturally, as our portfolio shifts from cash, an asset with price stability […], to securities with variable market values, our portfolio’s market volatility will increase.”
Recent additions that exemplify his investment thesis include Ascendant Group, which owns Bermuda Electric Light Company and Advance Auto Parts.
For full details about these acquistions, read Babineau’s letter to investors.
For more details on how Babineau and other portfolio managers are investing now, read our feature “Spring training for portfolios.”