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Inside the Market If NAFTA dies, it could be painful days ahead for the TSX and loonie

You wouldn't know from the upbeat look of the Canadian financial market that the North American free-trade agreement is dangerously close to being scrapped.

Canadian stocks have rallied more than 5 per cent over the past month, closing in on record highs. The loonie is hovering around 80 cents against the U.S. dollar, which is not far off its multiyear high. And bond yields are rising in anticipation of good domestic economic growth and higher interest rates from the Bank of Canada.

But if NAFTA dies after four rounds of unsuccessful negotiations and dismissive comments from U.S. President Donald Trump ("We'll see what happens," he said Wednesday), some observers expect the market's all's-good veneer will be replaced by something far more nerve-wracking: a diving Canadian dollar, falling stocks and loads of uncertainty about the economic impact.

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A U.S. withdrawal from NAFTA before the end of this year "would come as a surprise to most investors, who appear to have become quite complacent on the ongoing NAFTA discussions," said Ian de Verteuil, head of portfolio strategy, quantitative and technical research at CIBC World Markets, in a note.

Paul Ashworth, chief North American economist at Capital Economics, said the termination of NAFTA would be a "step into the unknown" – hardly a comforting idea for investors to mull.

"If the U.S. is determined to walk away, then they'll walk away," Mr. Ashworth said. "And then everyone suffers from that."

What should investors expect?

Some will no doubt look at Brexit as a potential template for what might happen. After Britain voted in the June, 2016, referendum to leave the European Union, financial markets were roiled. Global stocks lost $2-trillion (U.S.) in value within a day, and the British pound plunged 8 per cent and then continued to fall.

Since then, though, British stocks have rallied more than 20 per cent, suggesting that, for all the near-term concern, there wasn't actually much to get riled up about.

But the comparisons between Brexit and Canada only go so far. About 70 per cent of the revenue generated by FTSE 100 members comes from outside Britain, which means the lower pound is having a big impact on improving the competitiveness of British exporters. For companies in Canada's S&P/TSX composite index, though, just 50 per cent of revenues come from outside the country, which implies that a weaker Canadian dollar would provide less of a competitive boost.

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What's more, Canada is a smaller market on the global stage, and the country's popularity with global investors tends to wane when the loonie is weak. Add trade barriers to the U.S. market and Canada's popularity could nosedive.

"Many global companies think Canada is an extension of the U.S. (with a less rambunctious and more charming Head of State), given the existence of a preferred trading agreement. This positive perspective would fall away," Mr. de Verteuil wrote.

Ultimately, though, the market's reaction will depend on what follows NAFTA. Will the termination date be years away? Will a bilateral agreement take its place? And what sort of tariffs will exporters be subjected to?

David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates, observed that Canada might even emerge relatively unscathed, given that it has suffered disproportionately from NAFTA with losses to its manufacturing sector.

"The hit to Canadian trade is much worse than was the case for the U.S., with all deference to the complaints coming out of the White House," Mr. Rosenberg said in an e-mail. "Remember, we were just fine with the Free Trade Agreement, but we were dragged into the talks with Mexico kicking and screaming, but to no avail."

However, markets could be rattled if investors see the termination of NAFTA as a larger sign that the U.S. government is moving away from free trade and globalization, which have helped drive corporate profits for decades. Markets might even assume that the Trump administration will turn its attention to China next.

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According to Bruce Cooper, chief investment officer at TD Asset Management, investors could interpret U.S. trade policy this way: "We've dealt with target No. 1. Now there's target No. 2."

The result, he believes, is currency and market volatility, although he can't see more than a 5-per-cent decline in Canadian stocks given low interest rates and the upbeat global economic backdrop.

"The termination of NAFTA would have long-term implications, but they'd play out over a number of years," Mr. Cooper said.

In his report this week, Mr. de Verteuil said Canadian businesses wouldn't be devastated overnight but there would be "a slow bleed, over an extended period."

He singled out automotive suppliers and dairy companies as particularly vulnerable. Even Canada's big banks would likely suffer. Since the banks have offered an easy way for investors to bet on Canada when times are good, they offer an easy way to exit the country when times are turbulent – a view supported by Mr. Cooper.

As for specific companies that have benefited from NAFTA and therefore stand to lose from its termination, Foreign Affairs Minister Chrystia Freeland outlined two in a recent speech: auto parts manufacturer Magna International Inc. and oil driller Precision Drilling Corp.

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As for companies and sectors already embroiled in a trade dispute with the United States, such as Bombardier Inc. and Canadian softwood lumber producers, they would no longer be able to count on NAFTA's Chapter 19 dispute resolution mechanism to hear their side of the story. The result, Mr. de Verteuil believes, is a "more tortuous way" through U.S. courts and the World Trade Organization.

"None of these outcomes is positive for Canada, the loonie and Canadian equities," he said.

For now, though, investors see a low probability of NAFTA being terminated.

Instead, they are relishing the bullish backdrop. Corporate profits are rising, unemployment is low, and the world's central banks are sending upbeat signals. The International Monetary Fund has boosted its growth projections for the global economy to 3.6 per cent this year and 3.7 per cent next year.

"This is the most synchronized period of growth since the financial crisis and it is flowing into corporate profits," Mr. Cooper said. "Investors are focused on these powerful fundamentals rather than the risks associated with NAFTA."

But that could change.

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