Trump Tariffs: Taming the Unexpected

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In reaction to the erratic decisions that US President Donald Trump has been making since his re-election, the average investor will instinctively question their own strategy. The uncertainty resulting from this type of governance is compounded by the behavioural differences between the two North American economies. Rather than reacting on impulse, it is in investors’ best interests to understand how the current socio-economic context is affecting the markets.

Blurred or Double Vision

To say that the Trump administration’s tariff policies are causing some concern on the financial markets is an understatement. Their impact on real GDP growth and inflation scenarios, as well as on the likely response of central banks, is causing headaches among all economic stakeholders. While this instability clouds the outlook, it also highlights the contrasts between the economies on either side of the North American border.

Note: The scenarios described below are based on the clearest intentions expressed by the Trump Administration as of this writing.

A Matter of Proportions

With export/GDP and import/GDP ratios of 11% and 14% respectively, the US economy is a large closed economy. Imposing an additional 10% tariff on US imports from China and 25% on those from Mexico and Canada, even excluding the automotive sector, would increase inflation in the United States by roughly 0.5 basis points year-on-year, but only 0.2 basis points on average this year.

Combined with the retaliatory measures already announced by the United States’ trading partners, this inflationary shock would not be enough to cause a recession in the United States, but would rather lead to an economic slowdown. The impact would differ for the Canadian economy due to its smaller size and higher degree of openness.

Without even taking the automotive sector into account, the shock on exports would be enough to cause a recession in the Canadian economy. Based on some of our calculations, real GDP growth would record several consecutive quarters of negative growth, as Canada would lose market shares in the United States. This would imply a lower exports/GDP ratio, even in the long term.

Initial Tremors

Employment would initially be affected in export-oriented sectors, and other industries would suffer repercussions, resulting in a non-trivial rise in the unemployment rate. In response to this labour market shock, consumption growth would then turn negative. According to this scenario, that is, as of this writing, bearing in mind that customs tariffs could be lifted or not at any time, the Bank of Canada would choose to protect the Canadian economy by trying to limit the economic downturn. Aware that inflation is a lagging indicator, it should very probably ease its monetary policy aggressively from the current key rate of 2.75%.

Note: The table above compares certain economic indicators according to two sets of assumptions based on the information available to us at the time of writing this article. Naturally, the situation could change as the US administration makes further announcements.

This very particular economic scenario would be unprecedented in post-war history. Usually, a Canadian economic downturn results mainly from a recession in the United States. In the case under consideration, it would involve a Canadian recession without the end of an economic cycle in the United States, as it would result from a US tariff-related government policy.

What About Asset Allocation?

Without the lifting of tariffs, and assuming that they are maintained for a sufficiently long period, this dynamic would have a profound impact on the optimal asset allocation this year. An economic downturn always means a recession in earnings. Consequently, Canadian stocks would take a bigger hit than American stocks when the markets become aware that the Canadian economy is truly entering a recession, as hard economic data will start to be much weaker than expected. Moreover, the markets are not currently pricing a fully-fledged recession in Canada, nor a sustained differential between the Federal Reserve and Bank of Canada policy rates that would be consistent with such an isolated Canadian recession.

Furthermore, given that Canada is unlikely to adopt a strategy of blanket tariffs, unlike the United States, on Canadian imports from the United States, the inflationary impulse in Canada is not expected to be so significant, affecting specific categories of goods. An aggressive monetary policy easing in Canada, without being matched by the Federal Reserve, since inflation would edge up in the US, would also have strong repercussions on interest rate spreads between Canada and the US, particularly on the short-term part of the Canadian bond market.

While the Canadian yield curve is already lower than the US yield curve, a recession in Canada, which has not yet been fully taken into account due to too much uncertainty about the future, would mean a further increase in the fair value of the Canadian bond market (or a fall in rates across the curve). This means that interest rate gaps with the United States could prove to be even wider than the current spreads.

Learning Lessons and Seizing Opportunities

Regardless of the Trump administration’s next moves on tariff policy, we are already seeing the first effects of a trade war on the economy. The resulting uncertainty reminds us that no country emerges as the winner in such hostilities. However, it should be noted that emergencies often give rise to opportunities, such as the possibility of strengthening domestic trade across Canada and diversifying our economic relations abroad. We should also point out that economic reality often tends to catch up with the ruling class, as was the case in the past.

Such a surge in protectionism in the United States can only be traced back to the aftermath of the stock market crash of 1929 and the adoption of the Hawley-Smoot Tariff Act by the Hoover administration. At the time, Henry Ford had even put pressure on the president to dissuade him from signing this law.

As history tends to repeat itself, the three largest American car manufacturers recently urged President Trump to exempt the automotive sector from tariffs. The exemption they have been granted reminds us that despite the hard knocks suffered by the markets, their influence on decision-makers remains unwavering.