Over the weekend of 1-2 February, Australian time, US President Donald Trump fired the opening salvos in what might have become (and may yet become) a nasty trade war between supposed allies the US, Canada and Mexico. The tariff war didn’t immediately come to pass with both Canada and Mexico agreeing to extensions, but the tariffs on China and the Chinese response have since come into force. The 30-day delay agreed between Canada and the US on 3 February is set to expire on 5 March. The US has since indicated there will be tariffs on Steel and Aluminium, which are large exports from Canada to the US and recent comments from Trump are suggesting the tariffs will begin on 5 March. There’s always space for a last minute change of plan, though. In this article, we examine the impact of Tariffs on the US, Canada and their respective financial markets. In a coming article, we will extend the analysis to the wider world and the impacts on Australia.
Despite the new-found enthusiasm for tariffs from the Trump regime, the economic theory on tariffs is almost uniformly negative. Tariffs are highly inefficient and cause lower growth and higher inflation for any nation that imposes them as well as lower growth for any nation on the receiving end. As such, when a pair of countries engage in a mutual tariff war, the result is usually lower growth and higher inflation for both. What’s that saying about both sides losing in a war? It applies to tariff wars too.
For the moment, the US-Canada and US-Mexico tariffs are on hold but the brinksmanship is already starting ahead of the next deadline. Another extension is always possible but it’s also worth thinking about what would happen if a full trade war was to break out between those countries.
When you have a symmetric tariff increase, you have both countries facing materially higher costs for imported goods and no change to domestic demand. In our example, that is the US and Canada, but also the US and Mexico, and finally, the US and China. It’s worth noting that even though the US might come off better in each individual pairing, they could still be the worst affected country overall. The US has a comparatively small percentage of trade in its economy. Canada and Mexico have more, but the other countries are only in one trade war at a time, the US is in multiple trade wars at the same time.
Once tariffs are imposed, multiple imported goods will cost more. The only way this higher cost for imports can be absorbed is if consumers in both the US and Canada simply pay more for fewer goods. Over time, it is possible that some domestic producers will step in to the breach, but this will not be fast. Also, note that the “downstream” goods will also get more expensive if their raw materials are imported (and hence more expensive due to tariffs). Since the US imports a lot of energy and base chemicals from Canada, there will be a lot of downstream effects from goods which are produced in the US using imported raw materials. The artificially higher price of goods in the US and Canada lowers the consumption totals for the world. Therefore, inflation rises in the US, Canada, Mexico and China, but demand for goods falls in other places.
Initially, US bond yields increased, but over following days as the risk of trade war fell, bond prices moved back. But it was an important lesson for investors. The Trump Administration seems likely to be one that starts every negotiation with a high-stakes demand which creates both volatility and a higher risk of failure. It’s important to have a diversified portfolio that includes bonds to smooth over the volatility which is the unavoidable result.
However, the world does also appear to be cottoning on the fact that the high-stakes opening gambit is just that – a negotiation tactic. It might seem that the Trump presidency has started with a major jolt and an incredibly volatile period in markets. But it actually hasn’t. There’s been significant daily volatility and lurching from headline to headline, but the longer-term trends don’t look too different. In fact, since Trump’s inauguration, there’s been a small downtrend in yields, though not one that’s particularly material.
But that doesn’t mean that the new US approach to trade negotiations is costless - either for the US itself or for those targeted. The US data has turned a little weaker, with consumer confidence, in particular, looking poor. The University of Michigan sentiment index dropped sharply to 64.7 points last week, for example, and just recently the Dallas Fed manufacturing activity index has dropped from 14.1 points to -8.3 points.
This weakening of the initial post-election confidence is not unexpected, but is happening faster than I had anticipated. While it’s easy to bemoan government policy for being slow and unreactive, it is precisely because government policy is slow and unreactive that companies and individuals can perform long-term planning. Designing a factory or a global supply chain takes months and then is in operation for years or decades, all going well. Massively changing the underlying taxation of that supply chain makes these investment decisions essentially impossible to properly understand in advance. Companies respond by using simpler supply chains with fewer international connections.
This has the benefit of simplicity, but is usually less financially efficient. If the international structure wasn’t cheaper, no-one would be suggesting that design in the first place. So the marginal effect is to replace cheaper international structures with more expensive, fully domestic ones. From a certain populist point of view, that might be beneficial, but it does create inefficiency, and with it, lower growth and higher inflation. It is important to understand that even the threat of tariffs has this chilling effect, even if the tariffs are never implemented.
So far, the impact on the American economy has been relatively small, but it is only early days. We will need to see how things progress, but the risk of a greater slowdown and general weakening of the US economy is growing. Tariffs on the US’ main trading partners will add to inflation, but will slow growth even more. In that scenario, you tend to see equity markets falling, but bond markets moving sideways or rising slightly, since the bonds must also respond to inflation.