Loonie likely to fly higher with a Trudeau government, domestically-focused stocks may also get a boost

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The loonie is likely to regain its strength under a Trudeau government, although timing will depend on whether or not there is a majority government. A majority Liberal government should set the flight path higher soon after election night, while a minority could keep the currency in a holding pattern for a few weeks or months.

Although a number of factors drive currency exchange rates, in the short and medium term, direction is ultimately determined by sentiment. Currency traders and investors will likely welcome the Trudeau pro-growth platform. While some have raised concerns about the country going back into deficit, the amounts being discussed ($10 billion per year for three years) are modest and easily manageable. With a seemingly insatiable appetite for government debt globally, there is no reason to believe that Canadian bonds used to finance infrastructure spending wouldn't be gobbled up by both domestic and foreign investors.

One only has to look at the greenback’s experience during the early years of the Reagan administration. Coming out of recession, the US budget deficit grew, and the US dollar soared to record highs along with it. Interestingly, those deficits were piled up to help finance a jump in unproductive defense spending. While the scale of deficits proposed by the Liberals are tiny compared to the debts racked up during the early Reagan years, Trudeau would use funds to finance relatively productive infrastructure investments and to keep corporate tax rates low. The impact of the relatively small deficits compared to Reagan should be outweighed by Trudeau’s targeted approach toward productivity oriented investments.

Consequently, the nature of the Trudeau deficits should be viewed favourably by markets.

Unfortunately, monetary policy is in worse shape than it was in the Reagan years. In the early 80s, the greenback was still benefiting from Paul Volcker’s war on inflation when he kept rates high enough to ensure price stability. In Canada, right now we have Stephen Poloz shadow boxing with the "output gap." So far, the output gap is winning, having suckered the central banker into loosening monetary conditions in 2013. That led to hot money flowing into the oil patch precisely at the wrong time and throwing Canada into a recession.

A Trudeau government will likely force the Bank of Canada to get back to basics. That will mean focusing on inflation instead of trying to engineer industrial policy outcomes. A back-to-basics central bank would be good for the loonie.

Currency markets will not be so quick to celebrate a minority government situation. If the NDP have the balance of power, markets will likely wait to see if spending starts to take an unproductive turn. At this point, we believe the most likely outcome of a Liberal-NDP dominated Parliament is an accommodation of the NDP on social policies, particularly on the controversial Bill C-51 which the NDP want repealed. However, it will take a number of weeks, if not months, to know for sure how the policy dynamics of a minority government will work.

There is a risk that, once in power, the Liberals will embrace a weak currency as a means to support manufacturing. If they send signals in that direction, then all bets of a stronger loonie are off.

Should the Conservatives manage to pull off a minority government, we suspect the loonie will weaken as there will be uncertainty about how long the government can survive (unless it is only short by a couple of seats). A Conservative majority would likely be a short-term positive for the loonie as investors cheer stability. Any rally would offer a selling opportunity as the Conservative pledge to balance the books will be accompanied by more off-balance juicing of the housing sector through more loan guarantees to CMHC. The associated risks will eventually catch the attention of market participants. Moreover, the central bank will likely continue along its undisciplined ways.

Under a Conservative government, Stephen Poloz might well feel empowered to send the loonie lower.

In terms of stocks, the election outcome will not determine the fate of the resource-dependent Canadian market. However, in terms of the non-resource stocks, consumer stocks such as Canadian Tire (INK Edge outlook: mostly sunny; CTC), Dollarama (INK Edge outlook: mostly sunny; DOL), Hudson's Bay (INK Edge outlook: not rated; HBC), Riocan REIT (INK Edge outlook: mixed; REI), and RONA (INK Edge outlook: mixed; RON) could benefit as a Trudeau government cuts taxes for middle and low income earners. There is some evidence that this group spends more of a tax cut than higher income earners. More retail transactions could also be a small benefit for banks.

On the political flip side, asset managers such as AGF Management (INK Edge outlook: sunny; AGF) and mortgage finance companies such MCAN Mortgage (INK Edge outlook: sunny: MKP) would likely do relatively better under the Conservatives given the Harper commitment to increase tax free savings accounts and take measures to boost housing. These stock groups are relatively small compared to retail-oriented names and bank stocks.

While the winner of the election may have an impact on some areas of the Canadian stock market, the real action is likely to be in the currency markets. On that front, going short with the Tories and long with the Liberals is probably the best bet.
 

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