A NAFTA agreement could trigger a relief rally, boosting Canadian stocks

We've all heard the horror stories about what will happen if the North American free-trade agreement is terminated: The loonie will weaken, Canadian stocks will fall and the domestic economy will deteriorate.

But is it time for investors to bet that NAFTA will survive?

Carlos Capistran, an economist at Merrill Lynch, is sounding cautiously optimistic that a deal is possible, given a number of encouraging signs. If he's right, downtrodden Canadian stocks could get a boost.

In a note on Friday, released ahead of the start of the seventh round of trade negotiations that began on Sunday in Mexico City, Mr. Capistran listed his reasons why a deal looks within reach.

Among them: There has been a change in tone toward NAFTA from the U.S. side, U.S. tax reform has been approved, U.S. agricultural and auto sectors are lobbying for a deal, and a coming meeting between U.S. President Donald Trump and Mexican President Enrique Pena Nieto raise hopes that high-level talks could set an upbeat tone.

He's not expecting an agreement overnight, though: "Our baseline continues to be negotiations that extend for many months, followed by months for the approval process, with posturing ahead of each negotiating round. Remember that even after a deal is reached, the final approval could take many months, and it is unlikely to happen in 2018," he said.

But still, the fact that at least one observer is contemplating a resolution, however far off, makes you wonder if there's money to be made ahead of an agreement.

After all, Canadian stocks have been struggling amid six rounds of trade negotiations between the United States, Canada and Mexico, which suggests that removing this source of anxiety could trigger a relief rally.

Since August, when the first round of trade negotiations concluded unsuccessfully, the S&P/TSX Composite Index has lagged the S&P 500 by eight percentage points.

And over the past 12 months – a period that includes protectionist bluster from the White House (NAFTA is the "worst trade deal ever made," Mr. Trump tweeted in August) – Canadian stocks have lagged the S&P 500 by about 18 percentage points. The S&P/TSX has delivered a total return of just 1 per cent over this one-year period.

Admittedly, there have been other factors weighing on Canadian stocks.

Signs of inflation are raising expectations for additional rate hikes by the U.S. Federal Reserve, which is lighting a fire under bond yields and weighing on slow-growing dividend-generating stocks.

Canadian utility stocks, for example, have tumbled nearly 10 per cent since November and have delivered virtually nothing over the past year, even with dividends included.

Energy stocks are down 10 per cent over the past year, due in part to a discount on the price of Canadian crude and a bottleneck in pipelines. And gold producers have dragged down the materials sector by 7 per cent as the price of gold wanders aimlessly.

Conversely, some companies that were seen as particularly vulnerable to the end of NAFTA have performed significantly better over the past 12 months.

Canadian National Railway Co. is up more than 4 per cent, with dividends, even though cross-border trade accounts for an estimated 30 per cent of its revenue, according to BMO Nesbitt Burns.

Even better, Linamar Corp. is up nearly 15 per cent over the past year and Magna International Inc. is up nearly 22 per cent, although their auto parts exports require unfettered access to U.S. car manufacturers.

So have investors already concluded that NAFTA will live on? Perhaps.

But what's more likely is that the uncertainty hanging over NAFTA has been dragging on stock performance, even among companies whose shares are doing relatively well. According to CIBC World Markets, Magna shares trade at 9.5 times 2017 profit, a big discount to U.S. peers that trade at 12.1 times profit.

More broadly, the S&P/TSX stands out for looking cheap relative to the S&P 500. Canadian stocks trade at 18.2 times reported profit, according to Bloomberg News, versus 22.1 times profit in the case of the S&P 500.

Using estimated 2018 profit, Canadian stocks have a price-to-earnings ratio of 15.4, well below the S&P 500's P/E of 17.6.

A resolution to NAFTA just might even things out a little bit.