Canada's Trade Deficit and the Crosscurrents of CAD Volatility and Commodity Equities

The Canadian economy is navigating a complex web of trade tensions and currency dynamics in 2025, with the trade deficit widening to 2.7% of GDP in Q2-a level not seen since the Global Financial Crisis or the pandemic, according to BMO Balancing Act. This surge in the deficit, driven by a 42.9% annualized decline in goods exports due to U.S. tariffs, has triggered a reevaluation of investment strategies for both currency and commodity-linked equities. As outlined in the BMO GAM outlook, BMO Global Asset Management's 2025 market outlook underscores the volatility ahead, framing the Canadian dollar (CAD) as both a risk and an opportunity in a landscape shaped by U.S. protectionism and global capital flows.

CAD Volatility: A Tale of Depreciation and Contrarian Potential

The Canadian dollar has depreciated sharply against the U.S. dollar in 2024, trading near five-year lows and remaining undervalued relative to its long-term purchasing power parity (PPP) benchmark, a trend discussed in the BMO GAM outlook. This depreciation reflects the dual pressures of U.S. tariffs on energy and automotive exports and the Bank of Canada's muted growth projections, which now anticipate a permanently lower GDP trajectory due to trade uncertainty, according to the Bank of Canada outlook. However, BMO GAM argues that this undervaluation presents a contrarian opportunity. The firm forecasts a gradual appreciation of CAD through 2026, citing potential easing of U.S. trade tensions, a weaker USD amid global economic shifts, and a surge in foreign direct investment (FDI) inflows-reaching $23.1 billion in the four quarters to Q1 2025, the highest since 2008, as noted in BMO's Balancing Act.

This FDI-driven optimism hinges on Canada's ability to attract capital as global firms seek alternatives to U.S.-centric supply chains. BMO GAM recommends investors hedge USD exposure now, anticipating CAD's eventual rebound if Trump's tariff policies prove less severe than feared. Meanwhile, the Bank of Canada's analysis highlights a paradox: while CAD's appreciation has tempered inflation, it has also eroded the competitiveness of Canadian exports, creating a fragile equilibrium for policymakers (Bank of Canada outlook).

Commodity Equities: Export Woes and Diversification Hopes

The trade deficit's impact on commodity-linked equities has been stark. Energy exports, a cornerstone of Canada's trade balance, have contracted 11.7% year-to-date due to pipeline disruptions and lower prices, while automotive and steel sectors face similar headwinds from U.S. tariffs, as reported by The Globe and Mail. Yet BMO GAM sees a path for recovery. Canadian equities are positively correlated with CAD, meaning a strengthening currency could lift valuations in energy, mining, and other export-dependent sectors, a theme emphasized in the BMO GAM outlook.

The Bank of Canada's outlook reinforces this dynamic, noting that a stronger CAD will reduce the cost of imported machinery, potentially spurring business investment in 2027 as trade conditions stabilize. However, the near-term outlook remains challenging. Nearly 33% of Canadian manufacturers are diversifying markets outside the U.S., signaling a long-term structural shift that could mitigate-but not eliminate-the risks of overreliance on American demand, a trend highlighted by The Globe and Mail.

Strategic Implications for Investors

For investors, the interplay between CAD volatility and commodity equities demands a nuanced approach. BMO GAM's preference for U.S. equities in 2025 contrasts with its cautious optimism about Canada's trade relationship with the U.S. if tariffs moderate (BMO GAM outlook). A tactical rotation into Canadian equities, particularly in energy and materials, could capitalize on CAD's projected appreciation while hedging against U.S. market risks.

Moreover, the undervalued CAD offers a natural hedge for Canadian commodity producers, whose revenues in USD could gain a tailwind as the currency strengthens. However, investors must balance this potential with the near-term drag on exports and the Bank of Canada's warning that GDP growth will remain permanently lower than pre-tariff projections (Bank of Canada outlook).

Conclusion

Canada's trade deficit in 2025 is a double-edged sword: it has weakened the CAD and strained commodity sectors but also created opportunities for contrarian investors. BMO's analysis and the Bank of Canada's projections highlight a pivotal year for policy responses, trade diversification, and currency dynamics. As the global economy grapples with Trump-era tariffs and shifting capital flows, Canadian equities and the CAD may yet emerge as resilient plays-if investors can navigate the turbulence ahead.