Markets react to trade talks: Investors are betting on a U.S.-Canada deal

When the U.S. and Mexico reached a bilateral trade agreement without Canada on Monday, it was the end of NAFTA as we know it.

But stock markets rallied on the news, with Canadian stockshitting theirhighest point in more than a month. Today, the loonie is at itsstrongest against the U.S. dollarin more than two months.

Investors are betting on a deal materializing soon between Canada and the U.S., according to analysts, who say the Canadian market will follow its number one trading partnerhigher, despite the hurdles facingan agreement.

'NAFTAis not the problem'

Brian Belski, chief investment strategist at BMO Capital Markets, does not think investors are getting ahead of themselves by betting on a deal between the neighbouringcountries.

"Canada made the wrong bet hoping that negotiations would occur after the mid-terms [U.S. elections]and now, they are at a competitive disadvantage," said Belski."They underestimated President Trump and his overall negotiation strategy."

He thinks investors are also keeping in mindwhat happened inthe Canadian market in the second quarterof this year, when it rose more than six percent despite the trade war fears, outperforming most other developed markets.

"What consensus is missingis that companies with a majority of revenues outside of Canada have been outperforming most of 2018NAFTA is not the problem," Belski said.

"Remember, the S&P/TSX in local Canadian dollar terms, significantly outperformed the U.S in the second quarter and most investors missed it."

Focus on auto tariffs

As the majorityCanadian stockspared back gainson Tuesday, shares of the country's biggest auto suppliers Magna, Linamarand Martinreacontinued higher, rising up to more thanthree percent,bucking the broader market trend.

Derek Holt, head of capital market economics at Scotiabank, said an apparent resolution of major U.S. demands on auto tariffs in its agreement with Mexico, addresses the most important sticking points in its negotiations with Canada.

"Canada should find it relatively simple to join the U.S.-Mexico consensus on automobiles," Holt said in a note.

"The main change raising the North American regional value content for tariff-free trade in automobiles from 62.5 per centto 75 per cent would already be met by nine of 16 vehicle models currently produced in Canada."

Douglas Porter, chief economistat BMOCapital Markets, added that the U.S.-Mexicoagreement on autos was potentially positive for Canada, considering Mexico had been "securing the lion's share of recent new investments in the North American auto industry."

Market's 'end scenario' obsession

However, not all analysts are convinced that investors are not getting ahead of themselves by pricing in a deal.

Bipan Rai, head of North American foreign exchange strategy at CIBC Capital Markets, said markets have already priced in a trilateraldeal for valuing the Canadian dollar, but there is a significant chance the Trudeau government will decidethat the U.S.-Mexico deal does notsuit them.

"The market's obsession with what the end scenario looks like ignores the many permutations of how we'll get there," Rai said.

"A knee-jerk reaction [to a negative outcome]could take the loonie lower by a cent most likely. Over time, we'd expect markets to take the Canadian dollar-U.S. dollar crossback to around 0.75 centsat the very least."

The Canadian dollar traded at an average of 0.7742 cents US on Tuesday, up from Monday's average of 0.7701 cents US. That's its highest level against the greenback since early June.

Sadiq Adatia, chief investment officer at Sun Life Global Investments, agrees there is stilla lot of uncertainty in trade talks between Canada and the U.S.

"What is Canada willing to give up to get the deal done?," Adatia said."Also, Canada could potentially say that we will wait until the mid-term elections and hope that the makeup of congress is different which helps the current NAFTA deal."