Hello and welcome back to the Institutional Insights Podcast, where we share interesting and relevant topics for institutional investors. My name is Haley Hopwood. I am a portfolio manager with PH&N Institutional and your host for today's episode. In this episode, we're going to be diving into a topic that was talked about a fair amount in the lead up to the U.S. presidential election, and in the past few weeks, it's hit the headlines again.

And that topic is tariffs. And who better to help us dissect this topic but RBC Global Asset Management's Chief Economist Eric Lascelles. Eric, thank you so much for agreeing to be a part of this podcast today.

My pleasure. Thanks for having me.

Okay, so during the U.S. election campaign trail, we heard a lot about the threatened 10% tariff on the world and then the 60% tariff on China. And then seemingly out of the blue last week, Trump announced that Canada and Mexico could face a whopping 25% tariff on all products. And so, unsurprisingly, this surprised many Canadians and many of our clients have been asking questions about what the potential impacts could be for the economy as well as for financial markets.

So that is going to be the  focus of our conversation today. And I should also mention that Trump has more recently come out and threatened an 100% tariff on countries looking to establish a new reserve currency. Thankfully, Canada does not fall into that category, but I do still think that that 25% tariff is certainly not trivial.

So Eric, lots to talk about here. But maybe before we really get into it, we can take a step back and you can help us understand how tariffs work and the potential impacts that they have?

Absolutely, yeah. So, lots to unpack here. Let's  start, as you say right there, which is, what is a tariff, what are the main channels by which it interacts with the economy and businesses and so on? And so as a starting point, I mean, a tariff is a tax essentially applied at the time of importing a product into a country.

And, you know, the idea behind them, at least one of the reasons that president-elect Trump is proposing them, is that in theory, they can help domestic production. You're making it more difficult for foreign companies to come in, and so it does, in some simplistic way, help domestic production. So that sounds attractive.

Of course, tariffs also, to the extent they’re a tax, the government gets to collect some tax revenue and it's not your own citizens paying for it, at least not directly. And so there are some, you know, attractive elements. And so that I think is the selling card. The problem is, you then get all sorts of complications and problems that come along the way.

And so the reality is, it isn't usually just the foreign producer who ultimately carries the burden of a tariff. They pass along that higher cost to other parties. And so they pass it along to the wholesaler, and to the retailer, and to the consumer in the end, and actually the tariffs from 2017 to 2020 ultimately did land disproportionately on that end consumer, and somewhat less on everyone else along that supply chain.

So that would be Americans ultimately paying more money; so, higher prices and lower purchasing power. And one of the more subtle disadvantages when you put a tariff on is that you have companies, perhaps in the U.S. in this example, that are specializing. And so they're doing one thing very, very well. And suddenly when foreign companies are removed from the market, they are tempted to very much broaden out what they do. And often they end up being not quite as good, and so the loss of specialization can do some damage.

Less selection is another consequence. Usually these domestic firms aren't quite in a position to replace the foreign production, so the American consumers get fewer things to choose from. And of course, when you make any kind of change, if one company is being taken out of the mix and some other company is being put in, you end up with supply chain headaches, which we know are not something to be desired based on the experience of a few years ago.

So, you know, ultimately there are certainly more negatives than positives with tariffs. That's why tariffs are usually a net negative, even for the economy applying them, certainly a negative for the countries being hit by them. If the country being hit then reciprocates – and that happens a lot – then the country applying the tariffs is, you know, 100% guaranteed to be net negatively affected as well. So generally not all that desirable, but there you have it.

Perfect. Good explanation. And maybe just to set the stage a little bit more, obviously we know that Canada is an export-oriented economy and a lot of those exports go to the U.S.. Can you help us quantify that a bit, like how much of our exports go to the U.S. and what's the makeup of those exports?

Good question. So, it is certainly big. Around half of Canadian economic output is destined for export markets, so this is, you know, the classic small open economy. Obviously that means Canada is also importing other things to fill that hole, but nevertheless, about half of what we produce does get sold abroad. And the U.S. is – as I think as is well appreciated – the number one customer of Canada and, you know, 75-80% of Canadian exports go to the U.S. So it's not just number one, it is the overwhelming dominant fraction of the total. And so really, just multiplying those two numbers together, you could say something along the lines of, a third or so of Canadian economic output is U.S. demand.

 And so obviously, if U.S. demand were to falter on the basis of tariffs or some other reason, that is pretty consequential. So there's a lot at stake, for a country like Canada. And then in terms of the sector mix, I mean, it varies, of course, and Canada is a pretty well-diversified economy.

But, you know, oil and gas is the biggest chunk. Certainly their motor vehicles exported to the U.S. are another big chunk. Manufactured products are pretty big. I think that may include motor vehicle parts, which of course then become part of those vehicles and then you have a fair amount of raw materials –  wood, aluminum, steel, other metals, and food products as well. So we're fairly diversified, but the big, big ones would be oil and gas, motor vehicles, and then some of those raw materials.

Gotcha. Okay, so this affects the lion's share of our exports and a pretty diverse set of products. And so, could be a significant hit. So on that, if we did see these tariffs come to fruition – and I know there is still a big “if” there – but if we did see it happen, what sort of impact could that have on Canadian GDP?

It would be in theory, huge, and so again, I'm with you in wanting to emphasize the “if” and we're running a number of scenarios, and our most likely outcome is not the worst outcome. But I'll just give you a few numbers to mull over. So if we're talking Canada in the context of U.S. tariffs, with the presumption that Canada retaliates – and do note that, when you look back to the late teens, when Trump was last in power and did apply a steel and aluminum tariff temporarily in Canada, Canada did reciprocate with other sorts of tariffs. So you wouldn't be unwise in guessing some measure of reciprocation.

If you had a full 25% tariff, which I'll give away the ending in advance, I'm a bit skeptical of, in theory the level of output in Canada could fall by something like six percentage points. I mean, you know, that'd be spread over a few years. it would be partially offset by the fact that the economy normally might have grown at 2% a year, but you're still left with a significant economic hole and, you know, get guaranteed kind of a recessionary outcome.

If it were more along the lines of what was being broadcast on the campaign trail, as you referenced off the top, which is something like a 10% tariff on the world, which you know implicitly, I guess includes Canada, it would be proportionately less. So it might be, you know, a two percentage point hit, to the level of output, which you could overcome in the sense that that gets applied over a couple of years, the economy is growing over those few years, so the economy would still be bigger a few years later, but it would be quite painful and it would be, you know, approaching a recessionary kind of outcome.

More realistic, I think – but we'll get into odds in a moment – is, you know, probably more limited tariffs than that. And so what we're actually budgeting for is a hit to the Canadian economy, but more on the order of a little less than a half percentage point to economic growth.

So we think that it's smaller tariffs and so on, but either way, you know, there is a negative here. And one of the things I've had to do as an economist since this election is to, well, upgrade actually the U.S. growth forecast a bit. Not because of the tariffs, those are bad for the U.S., too, but because of the tax cuts and deregulation and other things.

And I've had to downgrade a little bit rest-of-world growth just because, you know, tariffs and maybe even a bit of a loss of competitiveness versus lower taxes in the U.S. and some other factors are such that we need to take a bit away from the rest of the world, including Canada.

Perfect. Yeah, that makes a lot of sense and, you touched on it a little bit, and we have been burying the lede here, but let's get to that ultimate question, which is really: will these tariffs happen, are we going to see this come to fruition, or is this just political posturing?

So I think ultimately, the odds of a 25% blanket tariff on Canada is pretty darn low. I think a 10% tariff is also fairly low. I do think tariffs are in play and, you know, Canada will be under some amount of pressure, and some of the familiar problem areas will become targeted again, be it supply management or the softwood lumber sector, and some other areas as well.

But I'm skeptical the tariffs will be, I guess, full bore tariffs. Do note that this is essentially a negotiating position for Trump, and if we look at the background, which is if he didn't ultimately actually apply that many tariffs to Canada and they didn't last for all that long, to the extent that some were applied in his first term, and we know he has surrounded himself with C-suite executive types who in general don't want economic damage, and don't want to see too much of this happen. And so I suspect that will be a temporary factor.

Trump does famously judge his performance, at least in part, on how well the stock market is doing. And so the stock market wouldn't be a big fan of extensive tariffs and, it may be I'm burying the lede within the burying of the lede here, Haley, in the sense that, explicitly that threat of 25% tariffs on Mexico and Canada was tied to border control. So the idea that too many illegal drugs are crossing borders into the U.S., too many undocumented immigrants are crossing borders, he wants people to do something about that.

And so reading between the lines, you don't get the tariff if you do something significant about it. I think it goes without saying that Mexico is very much more in the crosshairs than Canada on that front. That is, due to everyone's understanding where the bulk of the undocumented residents are coming from, and where most of the illegal drugs are coming from as well. So I think Mexico is under the greater of pressure, though Canada has already offered to up its spending on border security and that's, I think probably the right move.

And we saw, of course, Prime Minister Trudeau visit with Trump already and try to begin the process of smoothing things out. Do note that there are some limits, at least in theory, on the sort of tariffs that could be applied to Canada and Mexico, because of course, these countries are party to the USMCA trade deal, they negotiated this deal; you know, Trump made the deal, by the way, so he's likely to be more favourable to this one than to many trade deals. And, you know, it does dictate that there are not meant to be tariffs on most products that are being exchanged.

Now there are some loopholes here, and, you know, the U.S. does have the ability to declare national security considerations. And it depends how broadly one might interpret that, as to whether that applies just to tanks and fighter jets or to steel and aluminum or, you know, even more broadly than that. But there is, you know, some scope for U.S. action, but it almost certainly wouldn't be in a blanket tariff capacity.

And we think ultimately, he's angling just to get more border control centrally. I do think that maybe steel and aluminum could be at risk again; that was an area that was hit temporarily by tariffs, I wouldn't be surprised. And that can be, again, interpreted expansively as a national security rationale. I do fully expect Canada to be under pressure with supply chain management, with softwood lumber, with stricter border controls, almost certainly more military spending as well, because Canada doesn't spend that 2% of GDP on the military that NATO countries are meant to do, and that's something that has bothered Trump in the past.

And so I think that there will be some pressure there. I am assuming we get a little bit of tariffs. I'm assuming there is a little bit of an economic drag – less than a half percentage point off growth that emerges from that – but I'd be very surprised if it was the higher end of the possible scenarios.

Right. So reasonable to expect some tariffs, but probably much lower than what's currently being proposed. And maybe just keying in on one of the things that you said there, you talked about the USMCA and that being a potential barrier to tariffs, albeit with some loopholes. But this agreement is up for renegotiation in 2026. What does the future look like for the USMCA?

So, it is uncertain, I will admit. And you're precisely right, you know, this thing was built with the idea that there were expiry dates. I don't think anyone imagined that President Trump would be in power in 2026 when it expired since the scenario was, you know, if he had a second term, it would likely be ending now as opposed to starting now, but nevertheless, here we are.

And so it is certainly helpful that he did create the USMCA. So that does reduce the risk that it's thrown out, out of hand. I do think, though, that there will be significant efforts on the part of the U.S. to renegotiate certain aspects. And I guess the most obvious area is specifically with regard to, you might say, China throughput, primarily through Mexico, and the idea that China can evade tariffs that are directly applied to products coming straight from China to the U.S. by shifting things through Mexico and maybe adding some trivial additional item and then pushing it across the border.

And so, I suspect there will be efforts on that front. I think it's a little bit less specific to Canada. Last time around, one of the ways that the trade deal was struck was by adding, as an example, sort of minimum wages and you know, for cars to be eligible to avoid tariffs, they must be made with a certain labour share that earns, I think, at least $16 an hour as an example.

And so I think there are ways to keep Mexico in this, and just to ensure that there's sufficient value added being added in Mexico at a sufficient wage, that doesn't undercut U.S. competitiveness. And so I think there is a solution there, and that's maybe the most likely way things go. But I will admit that I can also see a scenario in which the USMCA doesn't survive, and instead you see the U.S. penning bilateral trade deals, and so Canada still has a deal with the U.S., it still looks probably pretty similar to the existing deal, but it doesn't necessarily include Mexico. And we've seen, you know, Canadian politicians also kind of distance themselves a little bit from Mexico because, you know, the problem Trump has with trade and with border control is primarily a Mexican one.

And so it wouldn't blow my mind if we walked away in 2026 or 2027 and there was still a trade deal, but it was only the U.S. and Canada and maybe there's a separate U.S.-Mexico one and, I don't know, a separate Mexico-Canada one, and those others might be a little bit more limited. So that's where we stand right now; I'd be surprised if we lost the whole thing. Do note, though, by the way, if somehow this whole thing was lost, you then revert to WTO rules. And WTO rules are pretty low tariffs, and so it wouldn't be great, but it wouldn't suddenly mean that trade between the countries ceases.

Okay, very interesting. Why don't we switch gears at this point and talk about market implications. So, the Canadian equity market, the TSX, it's very heavily concentrated in financials and resources. Unless we do see blanket tariffs, these don't really seem like the obvious targets for a number of different reasons. But what are your thoughts on this? Could we see some weakness from Canadian equities on the back of this?

Well I mean listen, by definition there's some exposure, and if there were to be an adverse tariff outcome then it wouldn't be great for the Canadian stock market. But I will say that the Canadian stock market, to my eye – this is an economist’s eye by the way, so take that as far as you'd like to – to my eye, it's a more limited exposure than the economic exposure in the sense that the Canadian stock market is not equal to Canadian GDP, and there's a very different sector mix and very different international orientations, and so on.

And so, you know, as an example, you hear almost nothing about the service sector when Trump talks about tariffs and of course the Canadian stock market is very heavily the service sector in the sense that financials alone are 30 to 35% of the total, and you know, setting aside the IT sector and the telecom sector and a number of other sectors that are also quite relevant, if somewhat smaller.

And so a big chunk of the stock market, probably approaching half, doesn't even have any particular threat applied to it right now. I will note that financials – which again, is by far the biggest single sector of the stock market, in the realm of a third of the total – it also kind of like some of the Trump deregulation.

And so, you know, often you think of deregulation in the U.S. as being an advantage for the U.S. and a disadvantage for Canada. But, you know, a lot of these Canadian banks and insurers and others have big operations in the U.S. first of all, and second of all, to the extent that the U.S. is now likely to drag its heels on the final implementation of international financial sector rules, like Basel III rules, it seems to me that actually there's a certain advantage gleaned even by Canadian entities.

So a big chunk not affected all that negatively at all. You do have the energy sector, which is about a quarter or as much as a quarter of the stock market that is in play. We don't know exactly what happens there, but I would suggest that one of Trump's dominant strategies from 2017 to 2020 is he likes low oil prices, he recognizes it makes people happy. And, you know, indeed, he's talked about drill baby drill in the context of the U.S., I guess there's a scenario where you can talk about that to the exclusion of Canada, but I really I don't think so. You know, he's talked about getting Keystone XL going again, which, which is certainly relevant to Canada; it would be quite a surprise of tariffs replied on oil and gas. And I think it would be to the detriment of him and to the detriment of Americans as well, and so I wouldn't expect that, but that's a big chunk. And then other chunks, maybe you speak with a little bit less conviction and confidence about the material sector, the industrial sector, you know, there is some chance of tariffs being applied to certain subsets of that.

And so that, that that's a risk. But, you know, combined, those are about a quarter of the stock market. And I guess the other thought would just be that keep in mind, many of these businesses, they operate in the U.S. or maybe they're actually obtaining materials from other countries around the world altogether. And so it's not all about the Canadian tariff rate, in any event, nor are all the sales happening to the U.S. whatsoever, so these are often very global businesses. So there's some exposure; I think the exposure is more limited in the stock market than in the economy.

And certainly not clear cut by the sounds of it. Now, as it relates to the Canadian dollar, tariffs would be a negative. We saw a little bit of weakness on the back of the announcement, and that's broadly retraced since that time. But a weaker CAD in itself makes things that Canadians import from the U.S. more expensive, which is inflationary, but then on the other hand, it helps the economy from a competitiveness perspective. Is one of these forces stronger than the other one? And could there be a resulting impact on monetary policy trajectory?

Yeah, that's a great question. There are a lot of moving parts in there, it hurts my brain a little bit to think too hard about it, but I would maybe fall back on some sort of first principles here, and say, certainly to begin with, you're quite right. You know, tariffs, and that threat are a net negative for the Canadian dollar, and indeed, we've seen it a bit lower.

I'd start just by saying, let's not overstate the effect. I mean, the currency is weaker, but we're talking about a percent or two, not five and ten and twenty, which is what you need to really get, you know, big inflationary effects and big competitiveness effects, and big monetary policy implications going, so let's not overstate that.

I would say all else equal, a slightly weaker currency does remove a little bit of the need for the Bank of Canada to cut rates, but I think it's a pretty slight effect, and it still looks entirely plausible to me that the Bank of Canada keeps cutting. And to me, the even bigger story than “inflation could be a bit higher from imports and competitiveness could be a little bit better,” is the story that of course, tariffs themselves are negative for the economy, kind of as established at the start. And so, you know, that still justifies some rate cuts in my mind. So I think the Bank of Canada can continue. We do seem to be entering maybe a more cautious and a slightly slower moving period where we may not need quite as many 50 basis point rate cuts, and it might be more of the order of the day to deliver some 25 basis point cuts, moving into 2025. But in general, I still think they can and I will say – not that I have a crystal ball for currencies – but I will say, we already see a fair chunk of that currency weakness priced in.

So, some amount of tariffs are priced in. Obviously, if it were to be the big ones that no one really fully assumes, then there could be a scenario in which the currency goes down further. But I'm actually more sympathetic to the idea that the Canadian dollar is getting fairly close to what could be a low. And, you know, when I look out over the next few years, I see an awful lot of pessimism around Canada and the economy right now, and rightly so; it's been a difficult slog and high rates of hurt and all of that sort of thing, immigration distortions and so on. But as I look to the future, I see rates that are coming down, and this is particularly beneficial to a rate-sensitive country like Canada. I see, an economy that might be perking up a little bit based on what we're observing.

You've got an election in the next year, and there's a chance that you end up with a policy mix that might be more productivity enhancing or some variation on that. I wouldn't be surprised if we're approaching at least peak pessimism on Canada and perhaps on the currency, and there could even be room eventually to start pushing in the opposite direction.

Okay well, that certainly sounds a bit more upbeat. And overall, I'd say it sounds like you're not really expecting to see material tariffs on Canada, certainly not in the order of that blanket 25% on all products that's being proposed out there. And what you do see is that it's likely to be a bit more targeted and shouldn't have a significant impact on broader markets. And so basically, what you're saying is that the tariff bark is likely to be worse than the bite. Is that fair?

That's exactly right. And not to completely trivialize it, but I think that's right. You know, realistically and just looking back on the 2017 to 2020 experience, it was scary, there were fraught moments, there were even a couple temporary tariffs that came on and then were removed later – but at the end of the day, Canada did not end up losing access to the U.S. market, and I don't think it's in the interest of the U.S., too.

And when you look through all the motivations that president-elect Trump has to threaten tariffs and even in some cases to implement tariffs, not a lot of them really apply to Canada, right? Canada doesn't have a big trade surplus with the U.S., Canada does not enjoy a huge, you know, wage advantage or competitiveness advantage to the U.S., Canada is a long-standing ally, the border isn't functionally the source of a lot of problems for the U.S. And Canada is very much on “Team USA” as opposed to, you know, a country like China that's on the other side of a geopolitical divide, and so on a number of fronts it would ultimately be surprising if Canada was hit by significant tariffs.

Excellent, that's helpful context. Well, Eric, I think that brings us to the end of our discussion here today. So, thank you so much for taking the time to join me on this podcast to talk tariffs and share your perspectives. We really appreciate it.

My pleasure.

And thank you to all of our listeners out there for tuning in to this episode. Hopefully you are walking away with some helpful insights. If you do happen to have any follow-up questions, please reach out to your Institutional Portfolio Manager. Take care, everyone.