A tariffible idea

• Economic fallout for Canada
• Action-reaction
• What’s an investor to do?

It didn’t take long for President-elect Donald Trump to make his presence known to his neighbours. In late November, Trump announced that on Inauguration Day in January he would impose a 25% tariff on all products imported into the United States from Canada and Mexico. Tariffs would remain in place until the two countries reduce both illegal immigration and drug trafficking into the United States.

Trump has described “tariff” as “the most beautiful word in the dictionary,” and he did use tariffs during his first term, primarily against China. While his stated motivation for the 25% tariff appears non-economic, Trump does view tariffs as multi-functional tools. For instance, they protect U.S. industries, incentivize reshoring of manufacturing, and, importantly, generate billions of dollars in new revenue for the U.S. government.

Given Trump’s affinity for tariffs, it’s likely we will see additional tariffs in Canada in one way, shape, or form. What does this mean for our economy, the markets, and how should an investor prepare for this?

Economic fallout

How important is the U.S. economy to Canada’s? Approximately 77% of our $590 billion in total exports are destined for the United States. In fact, exports to the U.S. account for over 20% of our annual GDP! Significant tariffs would increase the cost of Canadian products to U.S. importers, leading to reduced sales for Canadian exporters, job losses, and business failures. Some estimates suggest that a 25% tariff on all Canadian exports to the U.S. could result in a devastating 3-4% decrease in Canadian GDP.

Source: U.S. Energy Information Administration (EIA)

Such a huge negative adjustment to a massive driver of our economy would have direct and indirect impacts. For instance, one of Canada’s largest exports to the U.S. is motor vehicles and parts, with virtually all our production flowing south. In fact, parts often cross the border six or seven times before a car or truck is completed, highlighting how integrated the industry is between our two countries.

The direct impact on this industry is obvious, but what’s less obvious is the ripple effect this would have on our economy. As an example, Canadian railways move various products from Mexico and Canada throughout the United States. Decreased demand for these higher priced loads would result in fewer shipments, lower revenues, and layoffs. Businesses servicing railways would also suffer, reducing consumer spending in affected communities and amplifying the economic fallout.

Action-reaction

Trade is a two-way street and Canada and Mexico would undoubtedly respond with tariffs of their own, causing damage to the U.S. economy and exacerbating inflation. Having just come through a period of high inflation being fought with high interest rates, most consumers would be displeased to see this again so soon.

Canada exports 4.3 million barrels of crude oil and petroleum products to the U.S. per day, representing ~25% of U.S. oil refining capacity. The heavy crude Canada produces is essential for U.S. refineries and is not easily replaceable. A tariff on imports of Canadian oil and petroleum products would have an immediate and painful impact on U.S. consumers at the gas pump.

Another consequence of tariffs would be a strengthening U.S. dollar. While this may sound like a good thing, a strong dollar would make U.S. exports to the world more expensive, and therefore less competitive globally, further harming the U.S. economy. Overall, some economists estimate that the impact on the U.S. economy from Trump’s tariff proposal would be a decline in GDP by 1-2%.

What’s an investor to do?

The proposed tariffs would necessitate a substantial rewiring of North America's supply chain. Over the short to medium term, we would likely see economic slowdowns, shortages of goods and inflation. Of course, the proposal against Canada and Mexico made the largest headlines but threats have also been made against BRIC nations in general and China in particular. Tariff man is on a roll!

As investors, it's impossible to know what the outcome will be. Hopefully, for the sake of Canada, we agree to tighten our border and the threat subsides. After all, it’s against the U.S. interest to impose such sweeping policy. But given Trump’s love of tariffs, the threat will never fully go away.

In this environment, a mix of defence and offence is advised. Globally diversified portfolios offer some protection and resiliency as not all areas of the globe will be impacted the same from U.S. protectionism. However, to paraphrase Warren Buffett, don’t be afraid to be greedy while others are fearful. For instance, we saw the railway, Canadian Pacific Kansas City fall almost 3% on the tariff threat only to almost fully recover three days later. We expect investors will have many opportunities to take advantage of the uncertainty and volatility.

Sources: OEC, Trading Economics, U.S. Energy Information Administration (EIA)

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