U.S. President Donald Trump has overreached. He has made a huge misstep. We won’t need historians in the future to be telling us what is obvious today.
In the next few months and quarters, American households will no longer be blaming Joe Biden for an inflation breakout, especially for goods that are essentials. They will be blaming the current President. And as his polls slide, what ends up getting jeopardized is his ambitious and costly fiscal agenda as the GOP hawks in the House very likely grow more emboldened and less intimidated.
This is why this tariff gamble is likely going to end up being bullish as opposed to bearish for the bond market — because of what this is going to imply for other key parts of the President’s agenda. I suspect fiscal policy will be moving into gridlock, and this is not fully priced into Treasury prices at the current time.
And to repeat, the tariffs (and potential retaliation) could cause significant economic disruptions and ripple effects through the industrial sector. Canceled orders and cutbacks to production plans will surely trigger something else — layoffs. Even the greatest craps players in Vegas will sometimes roll snake eyes and I sense that Donald Trump just did that. The law of unintended consequences now awaits us.
The size and scope of these tariffs vastly outweigh what Trump did in his first term. He simply detests trade deficits and attacked Canada for no other reason than that. This tells me that he knows nothing about how the balance-of-payments in global trade actually works. The U.S. does indeed have a current account deficit with the world in goods and services, but ipso facto, it has a capital account surplus as well since, by definition, the balance of payments must balance. This is purely and solely an accounting identity, but for whatever reason, he and his allegedly super-smart cabinet members on economics don’t see it this way, even though it is an incontrovertible fact.
What is forgotten here is that the U.S. derives tremendous benefits from its capital account surplus position when it comes to the superior rates of return on investable assets that they enjoy. What the Trump Team doesn’t tell you is that the trade policy he is pursuing will necessarily imply a tightening in U.S. financial conditions.
This may well be part of Trump’s big and bold industrial strategy, but in the meantime, it will cause quite a bit of a headache for American consumers that he assumes will be swallowed with nary a pushback. Keep an eye on those public approval polls, which had already been declining in recent days. This action is more likely aimed at trying to take in revenue to placate the fiscal hawks in Congress and defray the cost of the mega tax cuts that are part and parcel of Trump’s budget plan. Either way, nobody wins in a global trade war; it is only about the magnitude of the pain.
Donald Trump seems to think that external producers will eat all of the tariffs and that revenues from the trade action will help pay for his bold domestic fiscal initiatives, but that is just an assumption. He has another assumption, that he stated verbally a month ago, which is that insofar as American consumers bear the brunt of any pain, they will be forgiving, and the pain will be short-lived. Assumptions all around.
Then, there are the political effects. Trump’s approval rating is already starting to recede. The honeymoon is clearly over, except for his die-hard supporters. He does not seem to realize that his success had much to do with the anti-Biden/Harris sentiment after four years of ineptness on many fronts. This was not exactly a vote to embark on a global trade war. One would think the citizenry would prefer stability in their lives, not high and rising uncertainty that could well impinge on their real incomes.
Let’s see how U.S. consumers react to a cut in their real take-home pay because what makes this different than Trump 1.0, is that back then, the tax relief came first and the tariffs (which were more targeted — solar panels, steel, washing machines — and far less radical in terms of size) came second. This time, the order has been reversed. And that is a problem for the U.S. economy, and not just Canada and Mexico. Cost-push inflation is coming our way; the only question is how much and for how long, and layoffs in the industrial sector are sure to mount as North American supply chains confront a major and unnecessary disruption.
Donald Trump may well be an expert on real estate, but he seems ignorant about global trade. In any event, the die is now cast, Pandora’s box is opened, and the laws of unintended consequences are soon to arrive. Not a time to be adding risk to the portfolio — gold (and maybe Treasury Inflation Protected Securities (TIPS) is likely a better a bet given its direct positive correlation to heightened uncertainty.
Mexico accounts for 23% of total U.S. food imports, and Canada supplies roughly 60% of all U.S. crude oil imports. Together, both countries are critical to the entire North American manufacturing supply chain — and both countries together represent nearly 30% of all global shipments that come into the U.S. Canada exports more than C$170 billion in energy products of all types stateside, and the auto sector, with its complex supply chain and re-exported inputs, are going to simply be devastated — Canada ships nearly $100 billion of transportation equipment annually south of the border.
Mexico and Canada have spent decades integrating auto operations with factories near the borders for parts and final assembly of vehicles. In fact, Mexico supplied the U.S. with 43% of imported motor vehicle body parts through November of last year, and Canada sent over 25%. More than 18% of the imports from Canada and Mexico have made-in-the U.S. inputs in them, far more than other countries, and this is a measure of the depth and complexity of how the production in North America is so intertwined — Canada’s re-exports to the U.S. are now verging on $50 billion annually, having doubled over the past decade! This is all going to prove to be an economic mess for everyone.
The hit to Canada is obviously going to be very severe: the average impact on real GDP growth in year one (as per the various BoC scenarios outlined in January) is -2.5% from the baseline of no trade war. That means we can expect a recession that looks a lot like the early 1980s and early 1990s. Not exactly a walk through the park. The effects on inflation are far more complex, but the average increase in the rate is close to +0.2% on an average annual basis (the impact here on prices takes longer to take effect and peaks at +0.8% by year three). Basically, the negative impact on the real economy in Canada is about three times that on inflation (versus a nearly two-to-one ratio in the U.S.) and the reality is that most measures of underlying inflation, appropriately measured, are running far below the mid-point of the 2.0% target range (which is 1.0% to 3.0%).
Ergo, the BoC will be cutting rates and cutting them hard from here, and the Canadian dollar will be destined to reach or breach the January 2002 all-time low of C$1.6128 (62 cents US). Just to bring the Canadian economy out of its current excess supply (output gap) alone would mean a move weaker to C$1.55 (64.5 cents US) in any event. All roads lead to a weaker loonie, which will be needed in any event to blunt the hit to the domestic resource and industrial sector.
And there is no doubt that Canada is going to need at least a C$70 billion fiscal stimulus package to offset the tariff-induced economic shock, which would still pale next to the C$360 billion that was spent to offset the economic damage from COVID-19 (C$90 billion of which was pure waste). That would mean a lot of budgetary red ink but would still leave the deficit-to-GDP ratio running between 4% and 5%, at least temporarily, and keeping in mind that the comparable number south of the border is set to top 6% for the third year in a row.
Canadians should consider the U.S. tariff as a deflationary economic shock of historic proportions. The BoC response (assuming no tit-for-tat trade war because retaliation will only make things worse) will be to cut rates -100 basis points more than would ordinarily be the case, meaning a move lower in the policy rate to around 1.5% (possibly lower) even with the Fed on a pregnant pause. There will, of course, be a currency reaction to all this, in all probability, a further -10% depreciation to C$1.60 (62.5 cents (U.S.)) — and that is the most effective way to combat a tariff from the imposing trading partner, no matter who it is.
So, plan for a 62.5 cent (U.S.) Canadian dollar, a 1.5% policy rate, and a 2.5% yield on the 10-year GoC bond as the fallout from any 25% Trump-induced tariff on America’s so-called “friend” north of the border. And focus your TSX exposure on the “bonds in drag” (Banks, REITs, Communication Services, and Utilities) and the beneficiaries of a weaker dollar (Travel/Tourism) and avoid the areas that are the most affected by the Trump trade action (Industrials, Materials, and consumer products).
David Rosenberg is founder of Rosenberg Research.