The first wave of tariff discussion is on our doorstep. A proposal from incoming U.S. President Trump has delivered a request to their North American trade partners – tighten up on border security (illegal immigration and drug trade) or face broad tariffs on what you sell to Americans.
The Matco Global Equity Strategy currently allocates 4.5% to Canadian investments. The direct impact of tariffs on our Canadian holdings is relatively low. The indirect impact is more balanced, to the extent that tariffs would impact Canadian GDP growth and the labour market.
We would assign a low probability to the outcome of broad tariffs on Canadian goods being implemented for a long period. Select tariffs, however, have a higher probability. Lumber, dairy, and auto parts have been sources of contention for some time.
Background
Canada is a major exporter to the U.S. You may recall the North American Free Trade Agreement (NAFTA) as groundbreaking cooperation to support free trade between the nations, of Canada, Mexico, and the U.S. Its origins began in the 1980s and eventually came into effect in 1994, paving the way for additional trade pacts globally. For the most part, NAFTA served its purpose. Still, during the 2008 U.S. election, during the great financial crisis, it came under fire for allowing Canada and Mexico to “take advantage” of the U.S. and was blamed for increasing unemployment. In 2017 NAFTA was formally re-negotiated in what was known as the United States – Mexico – Canada Agreement (USMCA) which came into effect in 2018.
Why the history lesson? Trade is always, and we’ll venture to say, will always be a source of contention. Taking a glass-half-full approach, this new round of trade discussion may be a much-needed uniting force for Canada – the premiers and the feds are scheduled to hold a First Ministers meeting this week.
Broad Economy
If, and we do mean if, these tariffs are implemented, they would impact Canadian GDP growth. Without knowing which areas will be impacted, a broad tariff on Canada is a worst-case scenario that could impact Canadian GDP by -0.5 to -1.5 %. In terms of an impact on earnings, it is in the range of 2-6%.
It’s rather unlikely that sweeping tariffs will become a reality as they also impact the U.S. economy, meaning compromise is the best solution to constructive trade negotiations. It takes time to build an auto plant or a dairy processing plant, which means the Americans are forced to either go without, import from elsewhere or pay a little more for imported goods as the exporter raises prices to defend margins. As always, it is a balancing act.
The Canadian market has taken the news in stride, should the tariffs be signed into law, we view a potential market pullback and a buying opportunity for high-quality Canadian businesses that may be trading at more attractive levels. In the meantime, collecting the dividends from our portfolio presents a source of cash to be deployed at a later date.
Sectors
Additional comments about our sector exposure within our Canadian allocation.
Finance: Major Canadian banks should only see an impact to the extent that tariff implementation impacts GDP and the labour market within their regions of operations.
Energy: Many U.S. refineries have made substantial investments to process Canadian heavy crude, the economics makes sense. Canada makes up about 60% of U.S. oil imports. An increase in costs, due to tariffs, would only result in higher prices at U.S. gas stations which isn’t very politically favorable. Following this logic, it's likely most of the energy space will continue to be exempt.
Mining: There is a limited expected impact. Many of Canada’s miners do not export directly to the U.S. For example, about 55% of Canada’s gold production is exported to the U.K.
REITs: The revaluation of REITs is directly linked to real GDP growth in Canada. If interest rates continue to fall, and the Canadian economy reaccelerates, then the valuation of REITs would improve. To the extent that tariffs dampen GDP growth, the revaluation is likely to stall. However, investors can continue to generate solid dividends from many of these REITs, waiting for the economic trajectory to clear.