Canada at a crossroads USMCA risks and sector winners

Canada’s outlook is fragile, with recovery hinging on how USMCA negotiations evolve. The key risk is not the market overall but widening sector divergence between trade-sensitive and domestic industries. For investors, outcomes will depend on whether trade uncertainty clears or persists.

Canada is not facing a broad market break, but it is entering a phase where the winners and losers could diverge sharply. The macro story is one of fragility rather than collapse: growth has been downgraded, the economy has slipped into a shallow technical recession, and the recovery now depends heavily on whether the uncertainty around the United States–Mexico–Canada Agreement (USMCA) clears or deepens.

This means, for investors, the sector story becomes the real focus. A timely deal would help trade-linked cyclicals regain momentum, while a drawn-out renegotiation would keep investors cautious and put the greatest pressure on autos, manufacturing, materials, and other export-sensitive sectors. Domestic, regulated, and cash-flow defensive areas should be better placed to absorb the shock.

Macro view: Fragile but not broken

A weak Q1 has forced us to cut our 2026 growth forecast to just 0.7%, down 0.3 pp, while keeping the 2027 one unchanged at 1.7%. The headline looks worrying: two consecutive quarterly declines mean Canada is now in a technical recession. But the details are less alarming. The setback was small, narrow, and likely temporary, driven largely by volatile trade and public-investment swings rather than a broad collapse in activity.

The economy is bending, not breaking. Consumers are still spending, firms are still investing, and the month of May delivered a powerful labor-market rebound. The catch is that spare capacity remains, with employment still below its end-2025 level and unemployment stuck around 6.5%–7%. A rebound should start to show in Q2 as trade normalizes, private demand edges higher, and fiscal support gathers pace. But this is unlikely to be a clean or vigorous recovery. Population decline, US tariffs, policy uncertainty, and oil-price volatility are all likely to keep the economy stutter along.

USMCA is where the story turns. A July 1 deal now looks unlikely, but we still expect the deal to get renegotiated by year-end, or latest by mid-2027. If that happens, a major cloud over trade should lift and near-term recovery should gain traction. If talks drag on, investment is likely to stay parked on the sidelines, leaving the recovery weaker and more uneven.

Inflation adds another layer of complexity. We have lifted our 2026 CPI forecast to 2.8%, up 0.3 pp, after energy pushed headline inflation to 3.2% YoY in May. But with oil prices easing after the US-Iran agreement to reopen the Strait of Hormuz, the worst of the headline pressure may already have passed. The more important signal is underneath. Core inflation is still contained, broader price pressure remains limited, and the Bank of Canada’s (BoC) preferred CPI measures are close to 2%. So, while headline CPI may stay sticky on food and energy, spare capacity and easing shelter inflation should keep the BoC firmly on hold through 2026.

USMCA: From trade uncertainty to sector dispersion

The recent International Emergency Economic Powers Act (IEEPA) court ruling seems not have materially altered Canada’s tariff position, as more than 85% of exports remain protected by USMCA exemptions. The more important issue relates to section 232, which was unaffected by the ruling and continues to pose a larger risk. For Canada, preserving free trade under USMCA matters far more than any direct effect from IEEPA.

USMCA mechanics: Why the review matters

The "sunset clause" within the USMCA stipulates that a formal joint review of the regional trade pact must take place every six years, with the initial review scheduled for July 1. Should all parties consent to an extension, the existing USMCA will automatically be prolonged for an additional 16 years until 2042, with the subsequent formal joint review set for 2032.

If any party rejects an extension, prolonged negotiations are likely. The parties may agree to a revised USMCA during this time, with talks possibly lasting weeks or months. Previously, the North American Free Trade Agreement renegotiations took over a year from initial discussions to a final agreement.

If no agreement is made to extend or change the USMCA, it will face yearly reviews until its expiration in 2036, creating prolonged trade policy uncertainty. If the pact dissolves, the countries may revert to bilateral deals, but differing rules and standards would raise costs for North American trade and investment.

USMCA scenario outlook

Our baseline assumes USMCA will continue to shield most Canadian goods, even as section 232 tariffs remain in place on selected products. Even so, the outlook remains highly uncertain. A breakdown in negotiations would likely raise tariffs, deepen trade uncertainty, and weigh on exports, investment, and growth.

The future of the USMCA will hinge on how effectively the three member countries address key challenges, from North American content rules and labor and environmental standards to penalties when US production moves to Canada or Mexico. Additional pressure points include Mexico’s government-controlled energy companies, competition from Mexican seasonal produce, and Canada’s regulated dairy, poultry, and egg systems.

The scenarios below show how different outcomes could shape both the macro path and the sector winners and losers (Figure 1).

CAD: Pressure first, optionality later

The CAD is likely to stay under near-term pressure as low real yields, weak growth, an accommodative BoC, and persistent USMCA uncertainty weigh on the currency. Canada’s sensitivity to higher rates and trade uncertainty has undermined confidence, hiring, and capex, helping keep USD/CAD elevated despite limited effective tariffs. Still, the outlook could improve later this year or in 2027 if domestic data firm and USMCA risks fade, with current USD/CAD levels already reflecting much of the bad news.

Sector view: Concentrated but not systemic risk

USMCA risk is concentrated, not systemic. The key exposure is in trade-linked earnings, supply chains, and investment plans rather than the whole S&P/TSX Composite Index.

Industrials, especially autos and manufacturing, and materials, notably steel and aluminum, face the greatest risk. Utilities, domestically oriented financials, and regulated cash-flow sectors should be more insulated. For long-term investors, the response is sector positioning, not wholesale avoidance of Canadian equities (Figure 2).

What the heat map actually means

Industrials and materials: The core of USMCA risk

Industrials and materials lie at the epicenter of USMCA risk, reflecting their direct exposure to tariffs, rules of origin requirements, and labor value content enforcement, particularly in automotive and manufacturing supply chains. Under scenarios where tariffs remain or exemptions are removed, margins and production flexibility come under pressure. Conversely, these same sectors are the primary beneficiaries in the most favorable outcome, as improved trade visibility would likely encourage renewed capital investment.

Consumer sectors: Selective exposure

Consumer discretionary sectors benefit from reduced tariffs and improved growth sentiment but suffer disproportionately in adverse outcomes as cross border supply costs rise and demand weakens. Consumer staples are generally more defensive, but dairy and food industries face specific policy risk given their prominence in the USMCA negotiation agenda.

Energy: Macro rather than tariff driven

Energy is less directly exposed to tariff lines, but remains sensitive to second derivative macro effects, including currency movements and growth expectations. As a result, energy sits in the neutral to moderate risk.

Financials, utilities, and communication services: Relative immunity

Financials, utilities, and communication services stand out as relative safe havens within the benchmark index during the review process. While financials are not immune to macro downturns, their earnings are far less sensitive to tariffs than industrial cyclicals. Utilities and communications services, supported by regulated and predominantly domestic revenue streams, remain the most insulated sector across scenarios, particularly when uncertainty rises.

Portfolio view: Position for dispersion, not exit

From an asset allocation standpoint, the USMCA review should be approached as a sector allocation problem, not as a binary trade decision. The baseline scenario remains the most likely outcome, but the worst case presents a meaningful left tail risk for specific sectors.

For most asset owners, we believe the optimal response is:

• Maintain exposure to Canadian equities, rather than reducing allocations outright.
• Underweight policy sensitive cyclicals (industrials and trade exposed materials), funding these positions through more insulated sectors.
• Use utilities and high-quality financials as portfolio ballast during the review period.
• Overweight policy sensitive sectors if negotiations track the baseline or most‑favorable outcomes, as those sectors could start to outperform quickly once uncertainty clears.

The bottom line

The USMCA review is a material but manageable policy event for Canadian equities. Its impact on the S&P/TSX Composite will be driven less by the index as a whole and more by sector composition and active positioning. By understanding where risks and immunities truly lie as summarized in Figure 2, asset owners can navigate the review period with discipline, flexibility, and a focus on long‑term value creation.