Talk of trade tariffs is dominating the headlines, and the Bank of Canada has cut interest rates by 25bps. Eric Lascelles, Chief Economist, shares his thoughts on the potential economic impact for both Canada and the U.S., the evolving political landscape in Ottawa, and why trade diversification is key.
Key takeaways:
Swirling tariff talk is concerning for Canada, with the country seemingly targeted above other key trading partners.
Political change could result in a positive outcome, in terms of trade negotiations, productivity gains, and growth.
Significant tariffs are likely to lead to an economic deceleration in the U.S. but a recession in Canada.
It’s clear that Canada needs to diversify its trade, yet there are challenges ahead.
An on-again, off-again environment is bad for business
At present, approximately 20% of Canada’s production is ultimately directly consumed by Americans. As tariffs are implemented and they start to impede flows, the impact on the Canadian economy will be concerning.
The Bank of Canada has recently cut rates. That may have been the case regardless, but certainly it is on a path toward additional rate cuts, relative to what might have otherwise been appropriate. I believe fiscal policy will also come into play over time.
A hardline stance against Canada
Some of concessions the White House is seeking from trading partners are not unreasonable, particularly increased military spending. Canada has been very light on that front for a while.
Additional resources have been directed toward Canadian border security, although arguably this is more of a Mexican issue. I think it's a reality now that the USMCA trade deal will also be renegotiated, with Canada likely in a position to oblige for that.
The bigger question is the extent to which reciprocal tariffs have grown beyond “if you have tariffs on us, we'll have tariffs on you”. They now seem to express a measure of objection to foreign countries (including Canada) that have sales taxes, exchange rates that aren’t at long-term fair values, and sectors that are traditionally protected, including in the U.S..
And so, some of the U.S. asks will be difficult to oblige to. As a result, there is a chance that tariffs, or at least some of them, will stick, as negotiations may not be entirely fruitful.
Questionable motives
The White House has protection instincts and the idea that it would be better for the U.S. to be self-sufficient. Yet, there are economic losses when one tries to do that. The U.S. has a fairly low unemployment rate, so it's not clear if there is room for additional industries. Plus, there is a loss of selection, variety, and quality when countries try to go it alone.
Canada does have a trade surplus with the U.S., although it’s not as large as has been articulated. However, it’s unclear why Canada is being targeted in terms of tariff attacks. Countries such as Mexico, Taiwan, and Germany have greater trade surpluses with the U.S., but have not been hit to the same extent.
Political change is in the air
The relationship between Trump and Trudeau has not been entirely constructive. And in a time of Canadian political change, one could argue that Carney is the right person for this time, in terms of prioritising the economy and finding a way forward from a trade perspective.
There will also be an election on 28 April. Until recently, the Conservative Party opposition was leading in the polls. That has narrowed, and now even reversed, as the patriotism expressed in Canada recently has favoured the incumbent Liberals.
Mark Carney is more of an economic centrist (versus a more left-leaning set of policies that pre-dated even under the same Liberal Party), while a Conservative win is also possible and envisions some significant economic changes. Each outcome should put Canada in a better position for growth, productivity gains, and in terms of negotiating with the U.S., to the extent that there may currently be some personal animosity at stake.
Make America (Not) Great Again?
Trump recently declared ”We don't need your cars. We don't need your lumber. We don't need your energy.” No doubt the U.S. could find other foreign providers over time and increase its production domestically. However, this would be at a cost. One of the charms of international trade is that countries specialise, and everyone is better off as a result. Every dollar of trade is voluntary, and therefore benefits all parties.
However, in the short term, this isn’t correct. Canada provides a lot of raw materials to the U.S., for example, 4 million barrels of oil per day1. This is over 20% of the oil supply. It's unlikely the U.S. could suddenly source that quantity of oil from elsewhere, and also unlikely that U.S. refiners could refine any other oil, even if they were able to find it. The oil refinery is very specifically focused on Canadian heavy oil.
A recession: pain in the US, greater pain in Canada
Tariffs, if applied in a significant way, could dim growth considerably in the U.S. and result in higher inflation and weaker economic growth. Yet, although markets are recoiling, I don’t believe there will be an outright economic contraction.
However, if a 25% tariff is implemented on 2 April, I believe the Canadian economy will begin to shrink almost immediately. At that point, I'd like to think there will be negotiations and smaller tariffs will ultimately prevail.
Yet, Canadians are very united around this and willing to suffer, and they are broadly in-line with the reciprocal tariffs being applied to the U.S.. And so, I suspect we will see Canadians rally and perhaps it will dampen some of the blow. However, at a minimum, the government and central bank are likely to be rowing in the right direction.
Canada: pugnacious, proactive…
As much as we're seeing slightly different strategies from different provinces – such as Ontario’s premier, Doug Ford, discussing applying his own tariffs on the U.S. – it's unconventional for a sub-sovereign level of government to be doing this. Ultimately, Canada is rowing in the same direction, with the prime minister, premiers, and others meeting regularly and on the same page.
If stage one of the Canadian retaliation is tariffs in a conventional way, there are other options that exist, such as limiting the export of certain critical products. I'm hoping that bridge doesn't get crossed, but that option does exist. And, of course, it's critical to Canada to get back on a proper trade footing with the U.S..
A long-term decoupling?
It’s hard to look too far ahead, however Canada recognises it needs to work harder to diversify its trade. It's been such a positive partnership with the U.S., that Canada hasn’t traded significantly with China and Europe, for example.
However, Canada’s ability to significantly pivot quickly is hindered for geographic reasons. These markets are already provided with goods they need, such as potash and oil, and it's not easy to transit some of these products to foreign shores.
I think we will see a scramble to reduce reliance on the U.S., yet I strongly suspect Canada's biggest trading partner will continue to be the U.S..
A flirtation with other partners
The obvious partnerships for Canada would be China and Europe, especially as Canada already has a free trade deal with the latter. There isn't room for an explosion of trade because the barriers have already been fairly low.
One of the challenges for Canada is that it has often had a contentious relationship with China, ironically, in part, due to the U.S.. For example, Canada put a large tariff on Chinese vehicles to synchronise with the U.S. tariff on these vehicles. China punched back at Canada recently and is now applying tariffs to various agricultural products on Canada.
There are challenges ahead, but Canada will do its best to diversify as much as it can.