BMO Equity Research: Impact of U.S. Tariffs on Canada's Economy, Equities, Oil, Autos, and Banks

Impact of U.S. Tariffs on Canada's Economy, Equities, Oil, Autos, and Banks- Transcript

Camilla Sutton:

Good morning, everyone. I'm Camilla Sutton. I run Equity Research for BMO for Canada and the U.K. I'm thrilled you could all join us this morning. We've got a great lineup. Impact of U.S. tariffs on Canada. Our speakers will each have five minutes to run us through their thoughts on how tariffs could impact Canada and the coverage that they have should the entire call should take us about 30 minutes and joining us today, we've got Michael Gregory, who's our Deputy Chief Economist, Brian Belski, who's our chief investment strategist, Randy Ollenberger, who's our oil and gas analyst, Tamy Chen, who's our consumer analyst, and will focus on autos, and Sohrab Movahedi, who's our bank analyst, and with that, Michael, I'm glad you could join us this morning. Over to you.

Michael Gregory:

Thank you, Camilla, and good morning, everyone. Well, you know, we all know what the news is. Canada got hit with 25% tariffs on non-energy exports. 10% on the energy side. Canada retaliated with 25% tariffs starting tomorrow on $30 billion worth of goods, and then in three weeks time, the same amount on another $125 billion, not full retaliation. You know, the bottom line is, for both the United States and Canada, but particularly for Canada, this is negative for growth. It's going to add to inflation. But the degree to which these things happen is a function of how long these tariffs stay in place, our working assumption, because we have to assume something is a year. Now, if that's the case, it has some meaningful impacts on the Canadian economy. You know, we were looking for about 1.9% growth for this year. That's going to be shaved about zero, so about a two-percentage-point hit to growth this year from these tariffs, if they last for a year, that's a little bit more than what the Bank of Canada talked about last week. You recall they're talking about two and a half percent, and reason why we're not as large as that is, number one, energy wasn't hit with a 25% tariff. It’s hit with a 10% tariff. And number two, Canada didn't have full retaliation, which, of course, minimizes the hit to Canada. So growth is weaker. Why is it weaker? Lower exports, lower investment broadly in the economy, but specifically in the export sector, we're getting disrupted global supply chains and an erosion of purchasing power because of higher inflation. We think CPI inflation, our baseline was 2%; we see that going up, on average, about 2.7% for this year based on that scenario. And the reason for the inflation is two-fold. Number one, we've this impact of tariffs, on retaliatory tariffs on Canada, which is, you know, it's going to add to higher prices for Canadians. But we also have a weaker Canadian dollar, which is broadly raising the prices of imported goods, not only from the U.S., but from around the world. The Canadian dollar, we expect to weaken, our forecast is, will drift to about 149 – we lost about a cent since Friday and we will be surprised, we got a few days where we actually top, you know, 150, the reason for the weakness in the Canadian dollar, one of those, of course, is strength in the U.S. dollar. One thing about tariffs, the country putting them on tends to see their currency appreciate. But also, we're looking for the Bank of Canada to ease significantly. And we see them. Our base case was by but mid year, they'd be cutting rates another 50 basis points, and that would be it for this cycle. We see an additional 100 basis points on top of that, bringing down the policy rate to one and a half percent. Now, what's that going to do is going to make negative spreads even more negative in the overnight segment, and that also contributes, along with a stronger U.S. dollar, to a weakening Canadian dollar. Now, if there's a silver lining, there's some good news. Here is the fact that, you know, lower Bank of Canada rates, a weaker Canadian dollar, which actually does provide that will help to the export sector a bit. And secondly, what we're expecting some pretty significant government relief measures that should, you know, lay the groundwork for an approved economy next year. And we're looking for growth of about 1% but that's still about shaved in half from what we're expecting before. Just keep in mind here that come April 1, you know the under the American Trade Policy Act, which, you know, the America First trade policy that President Trump signed on Inauguration Day, Treasury and Commerce and the office of the Trade Representative all have separate reports that deliver to the President, which I believe will make the groundwork for another wave of you know, section 201, 232, section 301, tariffs, the very much we saw in Trump 1.0 and more importantly, lay the groundwork for a global supplementary tariff, a GST of all things. And that's basically what, what the President is gunning for. So I do think the think about tariffs. I think they're going to be here for a long while, and I'll leave it at that for now. And over to you. Brian,

Brian Belski:

Thanks, Michael, thanks everyone for joining us here this morning. You know, times are tough, and this is where, from an investment perspective, where you make your money and I’d argue, we've been doing this for 35 years, and had to kind of deal with these types of reactions through time. We're not trying to minimize what could happen. We're trying to provide some common sense to what typically occurs. We published a piece of that just before midnight last night, if you're not seeing our work, Brian.Belski@bmo.com; we're humbled to be on the call here today for sure. So what we want to focus on is what is, what could come out of this. We are not going to be reactive. We are not changing our forecast. We're still at 28,500 for the S&P TSX, on earnings of $1,600. Here's why – we think that there are several names in Canada that can outperform the index with respect to just being good old-fashioned fundamentals. We continue to believe that there's a plethora of stock-picking opportunities. This is why we were bullish on Canada last year, when it was up 18%, the small cap index in Canada was up 16%, this is why we are telling people to be prudent in terms of their timing. Why? If you look back since the 1950s there's been 26 drawdowns in the TSX on a daily basis, more than 5% the average, the average recovery from those is 24.5%. Looks like there's a very good chance that we would be make an all-time new closing low today in terms of in terms of the TSX. Let's not be reactive. Let's use this as an opportunity. Why? Because everything that Michael's talking about actually is what the stock market traditionally fuels off of currency, lower interest rates, and all of that, we're going to have a bunch of analysts talking about their areas. But the second major point is in terms of the drawdown, in terms of the market in the Canadian dollar, typically and historically, when you have major, massive lows and troughs in the Canadian dollar stock markets up in Canada 12 months out. What about recessions now? Put this table in the report, and judging by the comments in conversations we've had with clients overnight and obviously this morning was let's just assume recession starts today in Canada. That's the way everyone's acting. That's the way the market wants to act. That's where the markets pricing things in. You go back historically and look at the last multiple of recessions, the first six months from the start of the recession, it's down an average of 4%. Why is that important, folks? It's important because if the markets down more than 4% today, we've already just kind of a recession. Think about that. Think about that. Now we're going to get all tied up and controlled by all of these macro things and oil prices and tariffs and all that kind of stuff. But if the market already prices a recession in a one-day drop, that's where you make your money. Lastly, in terms of other areas, we put out a list of companies in our report, again, it's just a list. It's just a screen. Those companies have a majority of revenues inside the U.S. from their operation that are that are not exposed with tariffs in terms of the product. Start thinking a little bit about that in terms of how you want to be positioned now this too shall pass. This is where we make our money, we need to be calm and invoke our discipline. We remain overweight Financials, which, especially those are going to be centered on the U.S., will do very well. Technology, especially those that on the U.S., will do very well. Consumer discretionary, especially those companies that will do very well. And REITs, here's why REITs, REITs underperformed last year. But also think about this, the Bank of Canada is going to come in with lots of liquidity, lower rates. REITs, very good on that. So let's be calm. Let's invoke and employ our process and discipline. And with that, we're going to hand the ball off to our great oil and energy analyst, Randy Ollenberger.

Randy Ollenberger:

Great. Thanks, Brian. So we've got a couple of pieces out on this. Back on January 20, we published a report looking at the supply demand balances, and came to conclusion that U.S. consumers are going to bear some portion of any tariff that gets in place, particularly those in the U.S. Midwest and U.S. Rockies, which have little alternative but to process Canadian crude oil. We've also published a report this morning to look at the potential impacts on individual companies. Now, one of the things we didn't take into consideration when we ran the sensitivity is a lower Canadian dollar. So you know, to the extent the Canadian dollar continues to weaken due to slower economic growth in Canada, as well as just overall uncertainty, that could provide a net benefit to Canadian oil and gas producers. And as a rule of thumb, basically every one cent change in the U.S. dollar is equivalent to $1 increase in the overall oil price. So as we look at the group this morning, you know the group has underperformed over the last month relative to its U.S. peers. We've seen the WTI-Western Canada Select differential increase by about $3 compared to where it was prior to the whole tariff discussion moving to the forefront. And similarly, the Henry Hub-AECO basis has increased by 75 cents over the same period of time. So a lot of this is already discounted into the market in terms of pricing, as well as oil and gas stock performance, the market has done a very good job at figuring out who is most exposed, and that's really synthetic oil producers and heavy oil producers, which rely really almost 100% on the U.S. market to place those products. And so we've seen companies like Meg Energy, Strathcona, and Athabasca underperform relative to peers such as Imperial Oil and Suncor, who are less impacted by tariffs. And in fact, Imperial Oil may be a net beneficiary, because they just process Canadian oil in their refineries, depending on how all this pricing works out. One of the other interesting things that we flagged here is that condensate should not get impacted by tariffs. Canada is a net importer of condensate. We don't produce enough of this stuff to meet oil sands demand. And so when we look at the share price performance of companies like ARC, which is the largest condensate producer in Canada, which is off more or less in line with the group, we don't think that that makes a lot of sense. And so that could provide a bit of an opportunity, because condensate prices should not be negatively impacted by a tariff, and to the extent Canada decides to pursue any retaliatory actions, condensate prices could actually go up and benefit ARC. So the bottom line for us here really is, obviously it's a tremendous amount of uncertainty. And the question is, how much of this is already priced into the stocks. Oil prices are up this morning, the Canadian dollar is down. And so from a cash flow impact, we may see very little impact on the company's actual financial results. You know, when we think about the current Western Canada Select price of roughly C$85, if that Canadian dollar continues to fall, it could fully offset any further movements in that WTI-Western Canada Select differential and on the natural gas side, as LNG Canada starts up in the middle of this year, we're expecting that to significantly tighten that basis spread, because there's really not enough gas to go around. And so natural gas producers, at the end of the day may not feel much of these tariffs either. And so net, net, to the extent we see any big moves downward in the group today, particularly with high-quality names. So think of your Canadian Natural Resources, MEG Energy, ARC Resources, Tourmaline. It really could represent a very good buying opportunity for these kind of companies, because we don't think they're actually going to be that impacted by any tariffs. And in fact, on condensate, we could actually see them as being a net beneficiary. And with that, I will hand it over to Tamy.

Tamy Chen:

Great. Thank you, Randy. So on the North American auto sector, they're right in the cross hairs of tariffs, because the average auto part crosses a border in North America between six to eight times. So if you imagine a scenario, where is it? 25% hit each time that happens. If that's the case, you can really see this, the compounding negative impact that has so several thoughts here. First and foremost, we cover three auto parts, names Magna is the largest, then Linamar and Martinrea. And let me just say in terms of revenue exposure. So this would be the revenues that all three of our companies generate out of their Canadian and Mexican facilities. And the key thing to note here is that a good chunk, in most cases, more than half, at least of the revenues from our companies is Mexican and Canadian facilities are shipping directly to the U.S., and so that exposure, so the amount of revenues our companies are generating currently from Canadian and Mexican facilities. For Magna, that's about 12% of total sales. For Martinrea, that's about a quarter. So 25% of sales. And Linamar does stand out as the most you know at potential risk, because not only is their autos at risk of these tariffs, but they also manufacture a lot of their agriculture and construction equipment in Canada and a bit in Mexico, and a lot of that gets shipped to the U.S. So for Linamar, when you combine both their automotive and their industrial segments’ revenue exposure, you're looking at, we estimate 60% to two-thirds. So Linamar really stands out as having the largest impact from tariffs. The second thing I want to know is we have to think about the impacts, and I'm going to focus on the automotive industry, so ignoring Linamar’s, industrial segment here. So the second thing we have to assess is, do we assume that the tariffs are in place for a year, and then it's ultimately a tactic to get to something else, like a renegotiation of the USMCA, or do we assume that 25% tariffs are permanent? If we assume that, let's say, as Michael's assumption for economics is, let's say the tariffs are in place for a year, while the challenge here for the North American auto sector is we're so intertwined. It's been decades of an entire continental block of supply chain that you can't, you cannot, in a year, start reshuffling supply chains and resourcing and replacing parts you get from Canada and Mexico to the U.S. It's too short of a time. It's impossible. So what that means over the near term? The key question here is, what percentage of that 25% tariff is going to get passed straight through to vehicle pricing. I've seen a lot of other assumptions that simplistically say all 25% of the tariffs will go right to the vehicle price, to be honest, I really think that that's too much to go right to the consumer. And if that still happens and the industry tries, I think there'll be a significant negative on vehicle demand over the near term. To be honest, the more realistic scenario I see is that every party shares a bit. I still suspect most of the 25% tariff will go on to vehicle pricing, and it will be negative for demand. So instead of flat demand this year for vehicles in the U.S., we might be down up to possibly five percentage points, which is negative for sure, and then I think the remainder, modest part of the tariffs will be shared between the vehicle OEMs and the part suppliers. And in that scenario, that, to me, is the worst case because depending on what you assume of the 25% tariffs are borne by our suppliers. That is full cost onto their onto their business, and our suppliers are already operating with very narrow margins. So, that would be the worst-case scenario. So we have to see what the industry decides to do over the near term with these tariffs. Over the long term, if we assume 25% tariffs are the new permanent norm, then, as you start seeing into year three, year four, you're going to start seeing reshuffling of the supply chain. And my sense is that Canada will ultimately be a potential net loser, even if you factor in the weaker Canadian dollar, will still make our exports appealing and be a partial blunt, a partial offset. The challenge is that Canadian vehicle manufacturing, our role in the North American supply chain is quite small compared to the U.S. and Mexico. And Mexico serves as the key low-cost jurisdiction. We do not. So if we have something like this as the new norm, and OEMs really do start gradually shifting their supply chain, I think on net, out of the three countries, Canada is more at risk. And lastly, what I'll say is what's priced into the stocks. So, I mean you can run all sorts of scenarios on your numbers. We're going to dial back down to a key valuation metric we look at when the auto industry is under significant stress, which is price to book. And if you look at the historical chart, right now, all three of our auto suppliers, price to book value is right near the March 2020, COVID lows. So we're there from that respect. However, for Magna and Linamar, their price to book is still higher than the absolute worst-case scenario we've seen in recent history, which is the 2008-09 crisis. If we go to a price to book value similar to ‘08-09, theoretically, there is still quite a lot of potential downside to both the shares of Magna and Linamar. I'm talking potentially up to 50% downside now I'm going to retrace to say that unless these 25% tariffs become the new permanent norm, I think that degree of downside for our stocks feels excessive. So what I'm saying is we might still have some additional sizable downside. I don't believe really, it'll be 50% downside. So the key thing is, we'll have to see how, over the next couple of weeks, the automotive industry tries to handle the 25% tariff, and with that, I will hand it over to Sohrab. Thank you.

Sohrab Movahedi:

Okay, thank you, Tamy. So the simple point on the Canadian banks is that while they're not in the direct line of these tariff fires, banks will nonetheless feel the impact of tariffs on the Canadian economy. As Michael mentioned earlier, you know, the expectations of higher unemployment rate, potential for a recession. I mean, these are all the negatives, but they face the uncertainty with strong capital liquidity and reserve levels. We've had a couple of notes out, short notes out since Friday with bank-specific details, but as a quick summary, at fiscal year end, Canada represented the highest proportion of the balance sheet and income statement for CIBC. National which, as of today, has also closed on the acquisition of CWB, so that number is gone up, and Royal Bank with Mexico also targeted by these tariffs. I think Scotia is very much in the mix. Conversely, BMO and TD have the highest proportion of their loans, assets, deposits in the U.S. and presumably, if you expect that the U.S. economy is going to benefit from higher economic growth, then those two are comparatively better-positioned, although TD has had this recent AML settlement that does put some growth restrictions on it; the two of them will also be best-positioned to benefit from tailwinds, on a depreciating Canadian dollar. From a valuation perspective, look the bank index has underperformed the TSX a little bit calendar year to date, about 100 basis points, trades at around 77% of the forward P/E of the market. But you know, during past recessionary periods, the bank index, relative valuation to the market has traded with a six handle. So we have not made any estimate changes or target changes for the banks under our coverage, but the Big Six will have dusted off the COVID playbooks, and as I noted earlier, the banks do enter this period of economic uncertainty from a position of strength. The excess capital across the group is about $47 billion that by itself, without any regulatory adjustments to the minimums, probably provides over $150 billion of lending power. Their liquidity is close to $380 billion in excess of minimum requirements. And they are very strong performing or unallocated reserves, close to $24 billion across the six, which is right around the COVID peaks. Still, we believe investors would applaud any pre-emptive reserve building in anticipation of higher credit costs, given the potential for higher unemployment and economic slowdown in Canada. It is hard to quantify how much will be required ultimately, in totality, because so much depends on the details and what happens next. But we believe any adds to reserve levels as a starting point will be well received by the market. Basically, something is better than nothing is our view on this. So to close it off, we do live in interesting times. Put your seat belts on, keep your hard hats handy, and know we are here to help. So do not hesitate to reach out to us directly or through your BMO Capital Markets representative. On behalf of Michael, Brian, Randy, Tamy and the entire team at BMO Capital Markets. Thank you for listening to our thoughts and good luck trading.