Tariffs, trade deficits and inconvenient truthsJun 15, 2018

Mexico and Canada saw their exemptions from US steel and aluminum tariffs revoked at the beginning of June, which raises the real threat of a trade war that would negatively impact all three NAFTA economies. Canada countered with proposed tariffs of 10-25% on approximately $16 billion of targeted US products including maple syrup (believe or not, an import!), whiskey, gherkins and ketchup, among hundreds of other products, potentially making summer barbecues more expensive for Canadians.

For their part, American steel and aluminum tariffs have raised input costs on US products for companies that use these metals, including Molson Coors. The company recently said the tariffs would amount to a $40 million hit to their bottom line if it didn’t raise prices or cut costs. Looks like summer barbecues on both sides of the border may be more expensive, illustrating the point that there are no real winners in a trade war, which is a tax borne by businesses and consumers.

A lose-lose situation

The recent escalation in pressure by President Trump and his team on Canadian and Mexican negotiators is intended to force concessions and a new deal ahead of US mid-term elections this fall. Additionally, the Mexican presidential election on July 1st means a deal, at least in principle, would be desirable by the end of this month. Although both Mexico and Canada have more to lose in terms of the size of trade relative to their economies, there are other costs to consider, like rising consumer prices that have a real impact to the US economy as consumption drives over 70% of US GDP.

What irks Canadian negotiators is that despite the rhetoric, trade is roughly balanced between Canada and the US, with a slight trade deficit or surplus depending on whether goods and services are included.

Between Mexico and the US, while tariffs could lead to an improvement in the US trade and current account balances versus Mexico in the long run, it’s misleading to evaluate the benefits of trade on this basis alone.

Auto manufacturing’s complex supply chain

Consider autos, for example. A car bought by a US consumer often has value added parts and labour from all 3 countries as part of a complex supply chain that has been built over decades. If final assembly occurred in Mexico, trade accounting might show the vehicle as a US import for $20,000, and yet this same vehicle could have been exported as a semi-finished good from the US to Mexico for $17,000. Trade accounting would simply record this as a net trade deficit of $3000 for the US, but that data says nothing about the possibility that much more value was added in the earlier stages of design, parts manufacturing, service providers, pre-assembly and more in the US, boosting the incomes of millions of US workers.

The North American auto sector is a complex eco-system that allows it to be a competitive global player. Lower Mexican input costs are a key part of the North American auto industry’s overall competitiveness in the cutthroat global auto market. The chart below highlights the significant auto trade between NAFTA members as part of the auto supply chain in North America. It would be a dangerous escalation for consumers and manufacturers alike to target the North American car industry.

Investment Implications

If a trade war escalates and slows global growth and boosts inflation, we think most global stock markets could fall in tandem. That said, if the current trade war dissipates, we remain optimistic about the prospects for global economic growth and global equity markets. In particular, we see value in select companies located outside the United States that have faster corporate earnings growth, as well as faster operating leverage. The Canadian dollar has begun to price in a falling chances of a new NAFTA deal in recent days, trading towards 76 cents to the US dollar. A cheaper loonie is our safety valve if trade talks go off the rails.

As I mentioned in a previous article, the bottom line is unpredictability often reigns with the current US administration. Trump’s personal negotiating style seems to favour creating chaos, often leading to changes that can be positioned as “wins” for his political base.

Stephen Lingard’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.