Balanced trade but imbalanced philosophies

Balanced trade between the U.S. and Canada masks major philosophical imbalances between Washington, DC and Ottawa on foreign policy and the role of multilateral institutions. Any silver lining amid these storm clouds depends on how the administration evolves its trade strategy and Ottawa’s reaction to it.

The Trump administration, having declared America’s persistent and widening trade deficit as public enemy #1 since before taking office, has followed through with several of its protectionist threats. Trade investigations under Section 232 of the Trade Expansion Act of 1962, have targeted products from countries and regions with the largest bilateral trade surpluses: China’s overcapacity and surplus production of steel and aluminum, as well as European Union (EU) and Japanese vehicles and auto parts.

But just because Canada and the U.S. have relatively balanced trade should offer little comfort to policymakers and investors as the next round of trade negotiations over the North American Free Trade Agreement (NAFTA) heads north (see the chart below). Quite the contrary. Canada potentially has even more to lose than countries that run large trade surpluses with the U.S., and Ottawa’s defiant stance in the face of American protectionism could potentially backfire.

Most of the U.S. demands in the NAFTA negotiations – the five-year sunset clause, the gutting of dispute resolution mechanisms and procurement rules, and U.S. auto content minimums – were already considered unacceptable to Canadian negotiators. Now, Canada – the largest exporter of steel and aluminum to the U.S. – is subject to tariffs on these items in exchange for progress on NAFTA talks (more on this below). Ottawa’s proportional retaliatory tariffs on a range of U.S. goods imports may have been unavoidable, but they deepen the economic impact and raise the temperature at the border. Canada is also the third largest exporter of cars and parts to the U.S. And whereas the metals tariffs apply to goods worth only 0.7% of Canadian GDP, the auto tariffs – if they were to go into effect and be applied broadly to countries other than the EU and Japan – would affect 3.4% of Canada’s economic output.

In light of the recently announced bilateral deal between the U.S. and Mexico, Canada will become the focal point for the U.S. administration over the coming months. Canada also has the most to lose from a NAFTA breakup, according to a recent working paper from the Bank for International Settlements, leaving Ottawa in a weak bargaining position. And although the U.S. and Canada both stand to benefit from modernizing the trade pact, America’s steel and aluminum tariffs, softwood lumber duties and attack on dairy supply management practices have poisoned the NAFTA negotiations and, until now, have sidelined the Canadian delegation from the talks.

But Ottawa’s philosophical differences with the U.S. administration on many fronts have also strained relations between Prime Minister Trudeau and President Trump:

  • The Trudeau government’s trade mission to China and public diplomatic spat with Saudi Arabia directly contradict the U.S. administration’s foreign policy objectives.
  • Ottawa’s World Trade Organization (WTO) complaint against the U.S., targeting the administration’s tactics in the softwood lumber case but also a wide range of other trade practices, has been met with Washington filing a complaint against Canada’s retaliatory moves against U.S. steel and aluminum tariffs.
  • Canada’s proposed WTO reform discussions slated for October exclude the U.S. and China, and Canada has likewise been excluded from US, Japanese and EU discussions on state-owned enterprises and state financing.

With federal elections due in 2019, the incentive for Canadian elected officials to publicly oppose Trump’s policies will not diminish. Prime Minister Trudeau has been rewarded in the polls for taking a tough stance on President Trump’s dismantling of international institutions and trade agreements. We will soon see if the bilateral deal between the U.S. and Mexico crosses any of Ottawa’s red lines.

Financial markets increasingly reflect heightened worries about America’s broadening protectionist agenda. The BlackRock Geopolitical Risk sub-index of Global Trade Tensions has risen to 2.5 standard deviations above its 13-year average, an indication that market participants are paying increasing attention to risks related to global trade and that such risks are likely reflected in asset prices. Globally, risk premiums have risen, equity valuations have fallen, and investors are rethinking portfolio allocation decisions.

While trade may be only one of the factors at play in the pricing of financial assets, there is evidence of investors reassessing their exposure to Canadian markets. Since 2017, Canadian equity returns have consistently lagged global equities, the Canadian dollar is one of the poorer performing developed currencies versus the U.S. dollar, and foreign investment in Canada has steadily slipped.

Fortunately for Canada, it appears that Congress, the U.S. Chamber of Commerce, the Business Roundtable and many state legislatures support a tough stance with China but a much less combative approach with its neighbors and allies. With the Republican Party potentially losing its grip on Congress in November, pressure may continue to grow to limit the administration’s blanket use of tariffs and its threats on NAFTA partners in its blind pursuit of more balanced trade. And procedurally, Congressional ratification would be much more straightforward if the White House kept to a three-party deal.

As we saw with the bilateral deal between Mexico and the U.S., if DC dials back its pressure on North American allies, this would likely be a modest positive for Canadian equities and the Canadian dollar. Given the considerable negativity already baked into the price, any trilateral NAFTA trade deal and renewed exemptions to steel and aluminum tariffs would be welcome news even if there is still a long way to go to get an agreement concluded.

Forward price-to-earnings multiples on the S&P/TSX Composite Index stand at just 85% of the S&P 500 Index – one of the lowest readings in the past 30 years, according to data from Thomson Reuters. Relative price-to-book multiples are likewise favoring Canada. Today’s extreme discount for Canadian stocks stems at least in part from a high degree of trade uncertainty. For a more enduring outperformance of Canadian stocks to take hold requires this trade uncertainty overhang to lift.

Kurt Reiman is a Managing Director and BlackRock’s Chief Investment Strategist for Canada. Kurt is a regular contributor to The Blog in Canada.

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