FidelityConnects: North American auto industry update and outlook – Analyst insights

[00:04:51] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. Canada is facing economic challenges and U.S. tariff stories continue to develop almost daily. How do trade tariffs impact the automotive industry in terms of consumer demand, the pricing and, of course, the supply chain? Consumer spending has been weak but can the increase of defence and government spending be supportive for our economy more broadly? How does government spending, such as infrastructure investment, impact sectors like transportation, housing? We're happy to say that joining us here today to go through the cycles of government spending and to discuss how the auto industry, and industrials more broadly, are being reshaped under the impact of U.S. tariffs. Joining us here to discuss that is equity research analyst, Robert Reynolds. We call you Bobby, nice to see you Bobby, how are you?

[00:05:41] Bobby Reynolds: Good, how are you, Pamela?

[00:05:42] Pamela Ritchie: I'm very well. Great to have you here with us. You're in the hot seat because there has been a jobs report in Canada and the U.S. It's actually brutal in Canada so there's a whole discussion there. I'm kind of interested what it means more broadly for probably the Bank of Canada and, therefore, how it might impact some of the sectors we're going to discuss today. You're here so we're asking you, what's the deal?

[00:06:05] Bobby Reynolds: For industrials I'll talk about the transports because they've been in the dumps for three years now in Canada. We're talking about rails and trucking companies. The major issue has been interest rates have been too high to stimulate demand in sectors like housing and autos that need lower rates to really have that volume go back to where it was from a pre-pandemic perspective.

[00:06:31] Pamela Ritchie: It's interesting because rates, obviously, have come down, they went up but they've come down again. What else is in there that would help from a rates perspective? There's still an overhang, basically.

[00:06:40] Bobby Reynolds: Yeah, rates have come down a little bit but there's still the locking impact where, in the U.S. especially, the average mortgage rate's 4 1/2% and now if you want a new mortgage it's still 6 1/2. So there's the locking impact, fewer people are moving, it's more expensive to buy a new home, and that's hurt freight demand. There's an element of if rates come down a lot more that can support some of these earlier cycle sectors like rails and trucking.

[00:07:11] Pamela Ritchie: Okay, really interesting. Lots of discussion of major projects and the Department of and how that's going to work in Canada. This is from a government perspective. The investment picture and thesis in terms of investment, actually, for your industries, has had a great government backing. Is that secular? Tell us how that sort of goes from here and where the consumer fits into that, I guess, but how have you been investing thus far.

[00:07:37] Bobby Reynolds: Government spending as a theme has been very positive for the markets over the last several years, really coming out of the pandemic. You saw major infrastructure spending bills passed in the U.S., Europe, Canada, and really around the world. That supported companies that service the public infrastructure space. You can think about the engineering consultants in Canada and the U.S., you can think about certain specialty construction firms. What the Building Canada Act does, in my view, is prolongs that upcycle in Canada, in particular, and, hopefully, you get even more projects off the ground because in Canada it can take a major project four or five years to get their permits. The goal of this Act is to shorten that time period to two years or less and, hopefully, stimulate the economy in the process. These have already been very strong stocks due to strong relative earnings growth and Acts like this can potentially prolong that period of growth.

[00:08:39] Pamela Ritchie: So interesting. If we take it specifically to the autos, we know that the mandate for EVs and to what extent the producers have to have X amount that they're pumping out as EVs versus internal combustion engines, what does the lifting of this mandate, which we kind of knew was gonna happen, what's the impact for the industry that you're studying?

[00:09:01] Bobby Reynolds: I'll take a step back. In the United States under the Biden administration there was a mandate for a certain percentage of vehicles to be electrified by 2030. If automakers did not meet that threshold there would be severe penalties. For every vehicle you sold you'd have to pay thousands of dollars in fines. Canada has a similar mandate where in 2026 20% of vehicles sold were supposed to be EVs. That ramped up to 100% by 2035. It's been reported over the last day that Canada is going to scrap the 2026 requirement and review the requirements over the longer haul. That was the stick that the governments were using to force vehicle manufacturers to invest in electric vehicles. Now that that stick is going away, especially in the U.S. which is a much more important consumer market, you'll see automakers discontinue certain electric vehicle lines. Most OEMs are losing money on every electric vehicle they sell and they'll also shift the priority of their CapEx probably to reshoring more production into the U.S. if you're an automaker from investing in electric vehicles. Ultimately, this just means likely higher returns on capital for the automakers and higher profits because you no longer need to sell electric vehicles at a loss.

[00:10:27] Pamela Ritchie: It just takes a loss leading part of the business out for now. How has your team, you and your team, been, really across all the industries, been picking apart this? I mean, the time that you must have spent to try and figure out how each layer of tariff is going to come in and then sort of the various second and third and fourth derivatives of those tariffs filtering through. Just tell us a little bit about what you and your team have been doing for the last several months on this front.

[00:10:55] Bobby Reynolds: It really started in November last year when Trump was elected. It started earlier than that because he was talking about tariffs throughout the election campaign. I don't think the market really started to take him seriously until late January or early February when you remember the fentanyl tariffs came in. We've been doing work on this since pre-election. You just need to sort out where are the exposures and what could this mean for earnings and then, it's a difficult decision, but what's the likelihood of these tariffs actually sticking. Peak tariff fear was early April when we got the Liberation Day tariff list. Generally, the market's been getting more comfortable with both the impact of tariffs and the likelihood that the U.S. backs down from the most punitive tariffs or the TACO trade as people have been calling it since then.

[00:11:49] One thing that is somewhat concerning is I think in some areas the market has potentially become complacent around the impact of tariffs with the view that we've already seen the worst in April and every deal negotiated will become more favourable to the trade environment. But in mid-August you saw the U.S. expand the scope of the steel and aluminum tariffs. Then you had Caterpillar have to cut their guidance recently as a result of the impact of that. The USMCA is currently still a tariff-free environment and...

[00:12:22] Pamela Ritchie: You say currently.

[00:12:23] Bobby Reynolds: Currently. What do we get out of that renegotiation next year? Is that going to be some baseline tariff or when the Canadian government hints to the press and the broader economy that some sort of tariffs are going to be on Canada are we just talking about autos and steel and aluminum, or are we trying to prep people that potentially there is an across the board, call it, 5% or 10% tariff. That's really up in the air and I don't think that that's the consensus yet that in Canada there's a baseline tariff on USMCA.

[00:12:57] Pamela Ritchie: Which, of course, is not free trade. I mean, we know this. We've been talking about this for some time. We go from mostly free trade, as long as you're compliant with USMCA, CUSMA, to potentially a blanket tariff of some. When you say that's not acknowledged or there's a complacency, what does that filter through? If you were to put that into terms of what companies will be having to be exposed to?

[00:13:23] Bobby Reynolds: 5% or 10% is likely manageable for most industries. It really depends on the specific industry structure and the pricing power of the individual businesses. There are definitely some broader headwinds that arise as a result of that. I think the one area where the market's gotten maybe more excited about the cyclical outlook, though, is while tariffs are happening and they are a drag, they've come off the worst case, and in the meantime you've had a very stimulative tax bill passed in the U.S., there's been deregulation. You have a more business-friendly government in Canada. You have interest rates that looks like will be cut again. I think the consensus is now over four cuts by January from where we are today. There's other offsets to help stimulate the economy. Tariffs aren't the only story. We just need to be cognizant of the potential landmines out there, if you call them, where a company is significantly exposed to that tariff risk that can negatively impact their earnings.

[00:14:24] Pamela Ritchie: We touched sort of off the top with jobs, rate cuts and rails, basically, sorry, transportation more broadly, and then also on autos just now, and we'll come back to all of those, but go to the aerospace space for us. This has actually been a bit on fire. It's actually been a great space and that's a demand story. It's a global demand story, isn't it? How does that impact the companies you follow?

[00:14:51] Bobby Reynolds: Canada has a world-leading aerospace sector in many respects. We're one of the two largest producers of business jets globally. We have world-leading space capabilities around communication satellites and robotics. We have very important pieces of the engine supply chain based in Montreal. Aerospace is one of the best exporting sectors in the Canadian economy. From a demand perspective, particularly on business jets, we can go back to the tax legislation, you can now deduct the cost of a business jet if you're a corporation.

[00:15:27] Pamela Ritchie: The U.S. tax story.

[00:15:28] Bobby Reynolds: Yeah, for the U.S., the U.S. being the primary source of customers for business jets. You can also think of business jets as being driven by high net worth individuals so there's a very high correlation between where the stock market is and where business jet demand is. Stock market ripping is generally helpful for demand. There's those elements of the story, there's also been an element of self-help for some of the Canadian companies that participate in that space. There's been all these elements that have just driven a very strong earnings and cash flow story. You've seen that show up in the equities. Space is also an interesting area to talk about, which I can go into now.

[00:16:09] Pamela Ritchie: Let's go into, absolutely, let's jump right there. This is the story of satellites?

[00:16:14] Bobby Reynolds: This is the story of satellites. The space economy has really seen a resurgence over the last three or four years as the reduction in the cost to launch satellites has enabled companies like SpaceX, and its subsidiary Starlink, to launch thousands of lower cost satellites into orbit and provide internet service at a competitive price to landline or fibre optic or cable-based internet.

[00:16:44] Pamela Ritchie: All over the world.

[00:16:45] Bobby Reynolds: All over the world. Now what you're seeing is satellite technology evolve to the point where we're talking about replacing wireless cell phone towers with direct-to-device satellites so that your phone, without you knowing it, can connect to a satellite instead of connecting to a wireless tower. Now, satellites aren't going to replace wireless towers in dense urban areas anytime soon but they could replace wireless towers in rural areas and provide a more cost-effective solution for telecoms to provide service in those underserved areas.

[00:17:20] Pamela Ritchie: Do the telecoms benefit from that? I mean, are they gonna be the ones partnering with the satellite story, or they're actually quite distinct?

[00:17:29] Bobby Reynolds: Ultimately, a minor benefit for them from a more efficient capital spending profile. The major beneficiary is the manufacturers of the satellites as these constellations get stood up. Canada has one of those. You've seen that respond, it's been one of the best performing stocks in Canada over the last several years.

[00:17:50] Pamela Ritchie: Can the cheap cost of launching a satellite happen without the aid of SpaceX? Is there another company that can launch satellites cheaply?

[00:18:00] Bobby Reynolds: There's multiple competitors for launch services, SpaceX is the leader by a mile.

[00:18:07] Pamela Ritchie: All over the world.

[00:18:08] Bobby Reynolds: Well, they launch out of the U.S. but they have customers all over the world. Currently the answer is no but that competitive ecosystem is developing and there should be more viable alternatives if you look ahead a few years.

[00:18:23] Pamela Ritchie: And is that private? Is that the government putting money there?

[00:18:27] Bobby Reynolds: SpaceX?

[00:18:28] Pamela Ritchie: To cheaper launching services.

[00:18:30] Bobby Reynolds: That's been driven by the private sector in the U.S. It's really a private sector story. You've probably heard portfolio managers like Mark Schmehl talk about SpaceX being an investment in some of his funds so Fidelity has been a private investor in SpaceX for a number of years and it's been very successful.

[00:18:49] Pamela Ritchie: Really, really interesting within that space of space. Anything else sort of on that front where we see entirely new systems on a national communication? It ties to the defence story as well, certainly.

[00:19:05] Bobby Reynolds: Certainly, Canada's announcement to target 5% of GDP spending on defence by 2035 has garnered a lot of interest, for good reason, in the market. There's not a lot of pure plays on Canadian defence given how small of a spending base it's been in the past but we do have some defence champions in Canada that can benefit from this spending initiative. You can come back to the space economy, we're leaders in space. If you're a military, there's actually already identified communications projects and earth observation projects that the Canadian military was intending to pursue but 10 years from now. If you're the government and you want to accelerate defence spending by 60 or 70% in one year, which is what the budget for this year calls for, it's those types of projects that you can look to accelerate. Again, if you're a provider of satellites you could benefit from that. It's a similar story around military training where we've got one of the world leaders in military training in Canada. You see the government trying to prior--

[00:20:14] Pamela Ritchie: This is from an aerospace perspective?

[00:20:16] Bobby Reynolds: From an aerospace persepctive. The government is trying to prioritize Canadian procurement for that 5% target so there are certain companies listed in Canada that should see multi-year tailwinds from the government's plans because the government doesn't move quickly so this is really a long-dated tailwind, not a quick peak and trough.

[00:20:39] Pamela Ritchie: We began saying, or you started off telling us, that it's been interesting structurally to be invested in things that the government is invested in or spending money on this is adding to. You mentioned engineering firms have been kind of the beneficiaries of that. How far into this are we? You've said it's, perhaps, extended the structural story that government spending will add and it's a good place to be when there's a consumer under some pressure. Where are we in innings? It sounds like the U.S. is much further, it sounds that Europe and Canada still kind of waking up to this, how would you rate that?

[00:21:14] Bobby Reynolds: We're middle innings on the public infrastructure story. It's been very strong since 2022, really. The growth rate has, potentially, already peaked in some countries like the U.S.  for the public infrastructure side  but still very strong growth rates. You can look at the Infrastructure Investment and Jobs Act in the U.S. which is driving a lot of the elevated public sector spend. But you've already seen the growth rates accelerate and now it's just where can these companies pivot to to see the next leg of growth? They benefit from the data centre buildout so that could be one area. They benefit from the reshoring story, that could be another area. They benefit from, potentially, using AI in their own businesses to improve their cost of doing business and delivering projects. There are still a number of earnings tailwinds if you look at a sector like that and Canada has world-leading businesses so the story's not necessarily over but public infrastructure spending, in particular, we're not early innings anymore.

[00:22:29] Pamela Ritchie: Okay, that's really, really good to sort of establish how that works. Autos, certainly, are the question of the day, the EV story. Question rolling in here for you, Bobby. The current administration removed electric vehicle mandates from the last administration. I think we're talking about Canada but you could also apply it to the U.S. How will this impact the U.S. EV sector and specific names in the longer term?

[00:22:53] Bobby Reynolds: Not only has the EV mandate being eliminated, which is positive for the legacy automakers because they were the ones selling electric vehicles at a loss, they've also, in both Canada and the U.S., removed the purchase incentives to buy an EV. In the U.S. you used to get up to $7,500 off the cost of an electric vehicle, that's now gone under the Trump administration. In Canada we had something similar. It was a lower dollar value, they've also allowed that to expire. There's no longer purchase [indecipherable]. If you're an EV pure play with no other tangential opportunities like robo taxis or autonomous vehicles it's a much tougher environment in which to be successful.

[00:23:37] Pamela Ritchie: Okay, that's really interesting. The legacy players have had, in a way, a burden lifted for now, at least in the short term, I don't know what the longer term looks like, but those that are pure play, are there opportunities for pure play companies in this country to be established in electric vehicles?

[00:23:54] Bobby Reynolds: Highly unlikely. It hasn't happened already. The Chinese EV sector and Tesla in the U.S. are miles ahead of everybody else, unlikely.

[00:24:07] Pamela Ritchie: Okay, really, really interesting. When you look at the consumer, the demand story, and even just sort of the realignment that you and I were discussing a headline about, had more to do with immigration workers in factories and so on in the U.S., a headline there, but it is a discussion about a retooling of a workforce, the reshoring element comes into that, and we're expected to hear, as you say, major projects and so on coming online from the Canadian government, just talk a little bit about the labour supply, the story, what we're going to be able to get off the ground soon, or are we looking pretty far out? Is there a muddle through here until we get things moving?

[00:24:48] Bobby Reynolds: From the labour supply perspective, as you can see from the employment data it's still a pretty low unemployment rate in the U.S., it's growing in Canada, but there's not a ton of slack in the U.S. I think this is one of the issues that most companies I talk to bring up when I say, are you going to be forced to relocate a factory to the U.S. from, say, Canada or Mexico or Asia? The availability of skilled labour is a huge issue in the United States.

[00:25:19] Pamela Ritchie: So is the answer, yes, I would if there were workers there?

[00:25:24] Bobby Reynolds: It's I'd be more likely to. They'd still prefer not to but given the tariff situation they might be forced to. In Canada there's a little bit more labour slack. We have cut our immigration targets in Canada as well. In most sectors, there's a fair amount of slack. I think there is more labour tightness in certain areas like the resources sector in Canada, especially in the hard metals mining like copper and gold. It's definitely a hot sector right now. You could see in the public infrastructure space more tightness and labour cost pressure as the Building Canada Act gathers momentum and some of these mega-projects get off the ground. Again, given we're talking still two-year permitting timeframe instead of four years there's time to plan for that as it comes.

[00:26:15] Pamela Ritchie: In terms of the labour supply story. In the U.S., there's lots of questions swirling around but one of them is, are companies not hiring because there's no one to hire, or is it another story? There seems to be a balance of questions there.

[00:26:28] Bobby Reynolds: It's a very sector-specific question. There are certain areas of the U.S., if you think about close to the Mexican border where traditionally a higher proportion of the labour supply in some areas like freight and construction and maybe some services businesses like lower-skilled services businesses where that labour pool is shrinking and it can cause shortages, productivity issues and project schedules to be delayed because there are instances where people are afraid to show up to work because of these immigration raids that are occurring in the U.S.

[00:27:08] Pamela Ritchie: We are hearing about that. Back to Canada and the major projects discussion, some have been actually announced. This high speed train sounds like it's a goer from a government willingness perspective, whether that comes off or not. That's to connect Quebec and Ontario all the way through in high speed rails. Pipelines as well from the oil patch to the west coast, on an infrastructure side of things what is of interest to an investor?

[00:27:38] Bobby Reynolds: We can come back again to if these projects happen which companies benefit.

[00:27:43] Pamela Ritchie: How much is the if there?

[00:27:45] Bobby Reynolds: Some of them are highly likely to happen. Nuclear plants were one of the projects listed. We're already building a small modular reactor at Darlington and the government has announced plans for two new large nuclear sites, one near Port Hope and one is an extension of the Bruce nuclear in...

[00:28:05] Pamela Ritchie: Northern Ontario.

[00:28:05] Bobby Reynolds: Northern, not northern Ontario but on Lake Huron.

[00:28:09] Pamela Ritchie: North from Toronto, I should have said that.

[00:28:12] Bobby Reynolds: There's a Canadian company that owns, not owns but licence the CANDU technology, the Canadian homegrown nuclear technology. It's these sorts of secular opportunities where you just look at where's the demand growth going to be there for the next 5 or 10 years, that can be really interesting. High speed rail is a good example where the government committed to spend $4 billion over five years just to study the project, not to build it. If you're going to build that, that's starting four or five years from now. The industry estimates are this is $100 billion plus project. At that point if it gets built it could be a big opportunity for equipment dealers, for construction firms. At this point it's a benefit for the engineering firms that are studying it. They're at the earlier end of the project life cycle and hence can see a revenue growth opportunity sooner.

[00:29:16] Pamela Ritchie: When you hear pipeline announcements, I mean, there's a big discussion about where pipelines are going to go and corridors and so on but we have one announcement here. Again, is it a long way out? It goes to the office of major projects.

[00:29:29] Bobby Reynolds: I believe it was the Globe article that reported the list of major projects, suggested another pipeline from Alberta to the B.C. coast. I don't know if there's any funding backing that at this point. You would need to find someone to actually own that project. The government doesn't want that to be another publicly funded project like the TMX project, I believe they'd rather have the private sector do it. A lot of things still need to get worked out for that to go ahead, whereas in the case of high-speed rail, that would clearly be a government funded project. It would not be owned by the private sector.

[00:30:10] Pamela Ritchie: And ports, I mean, it goes into the infrastructure side, in some cases, there are international players who are gonna come in and sort of build the infrastructure themselves using Canadian workers, presumably, but again, opportunities to invest, is that kind of the same story?

[00:30:22] Bobby Reynolds: Certainly. Canada's ports are owned by the Canadian government through the port authorities but they are operated typically by a private sector company all of whom are multi-nationals, so not based in Canada. The actual upgrades to the ports would likely be publicly funded. That would be, to your point, Canadian construction firms that would benefit from that activity initially.

[00:30:46] Pamela Ritchie: We just have a couple of minutes left but I'd love to ask for sort of the fascinating story of rails. It does seem to be a very North American story, obviously, two big Canadian players who have been kind of in the doldrums, actually. Where do we see this going? Give us a little bit of a landscape view of there are a number of North American operators, where do we fit within the rails story in North America? I'm sorry, I'm only going to give you a minute to answer this one.

[00:31:13] Bobby Reynolds: Oh, that's fine. I think what you're referring to is the rail M&A story--

[00:31:17] Pamela Ritchie: There's tons of them.

[00:31:19] Bobby Reynolds: --that came out this summer. There's six class 1 North American rails. Five of them are public, two of them are Canadian, three of the public ones are in the U.S. Union Pacific announced it would like to merge with Norfolk Southern in August and that set off a lot of market discussion around how do the dominoes fall after this? The structure of the U.A. rail networks is there's two rails in the east and two rails in the west. Union Pacific and Norfolk Southern is one east, one western rail. How can you not have the other western and eastern rail merge if UP and NSC are allowed to merge because the remaining two would be at a competitive disadvantage. The remaining western rail is Burlington Northern, which is owned by Berkshire Hathaway, obviously, controlled by Warren Buffett. Berkshire Hathway has come out publicly and said, we are not interested in buying another rail at this time. At this point the sector wants to see how this potential UP, NS merger goes through the process what concessions need to be made.

[00:32:24] Pamela Ritchie: For the regulatory?

[00:32:26] Bobby Reynolds: Yes. The Canadian rails have a seat at the table here because they're going to ask for concessions. They have a large U.S. network, and Mexican in the case of CP, potentially, they could be involved in consolidation in the industry, either as an acquirer or as a target in the future. To me, it's difficult to see how geopolitically you could have a Canadian rail merge with the U.S. rail currently but over the long term  you could go from six to two North American railroad networks if consolidation is allowed to play out.

[00:33:03] Pamela Ritchie: I feel like every time we meet over the course of the next, whatever, we're going to bring this up because it will inch along and you'll bring us the updates on a pretty fascinating industrial story.

[00:33:13] Bobby Reynolds: Certainly.

[00:33:14] Pamela Ritchie: Bobby Reynolds, thank you for joining us, bringing us up to date and letting us know what you and your team are digging into on a daily, minute-by-minute basis on behalf of all the investors. Thank you.

[00:33:23] Bobby Reynolds: Thanks, Pamela.

[00:33:24] Pamela Ritchie: That's Bobby Reynolds joining us here today. Coming up next week on the show, Monday, Director of Global Macro, Jurrien Timmer, joins us to dive into the latest macro themes that are in his radar and probably should be on your radar as well. That is on Monday.

[00:33:36] On Tuesday we check in with portfolio managers, Connor Gordon and Chris Maludzinski. They take a look at the Small Cap Opportunities Fund, this is what they manage. They are keeping an eye on some fascinating stories there and they'll discuss what under the radar industries and themes, ultimately, they are seeing and how the current market environment is influencing their fund positioning. That's Tuesday.

[00:34:00] Wednesday we welcome special guest Andrew Bevin. He is national campaign co-director for Prime Minister Mark Carney. He's also CEO at Catalyze4 and he'll take us behind the scenes and offers perspective on the policy agenda in the upcoming fall session of Parliament, big nation building projects, of course, and the latest in the Canada-U.S. relations story. Thanks for joining us. Hope you join us next week. Have a great weekend. I'm Pamela Ritchie.