Commentary
Trade Wars Are Starting: More turbulence ahead, but cautious opportunities lie ahead
What many believed to be a hard-line bluff and negotiating tactic, for which President Trump is well known for, is now reality: across the board, steep tariffs have arrived on key U.S. trading partners (Read: Trade War Impacts: First Pass).
February 05, 2025
Could a Global Trade War Derail the Equity Bull Market?
What many believed to be a hard-line bluff and negotiating tactic, for which President Trump is well known for, is now reality: across the board, steep tariffs have arrived on key U.S. trading partners (Read: Trade War Impacts: First Pass). Markets responded negatively to confirmation of the rumour, but it’s still not clear what the policy outlook on trade will look like next week, next month, or next year. But within hours of implementing tariffs and after a few phone calls and changes of border policies (more troops at the border), Canada and Mexico managed to delay tariffs for one month. This friendly turn of events helped markets to recover and fuel speculation that tariffs might be dialed down in a not-too-distant future. While we expected a bumpy first one hundred days in office for President Trump, imposing punitive 25% tariffs was a surprise for investors.
While the economic mechanics of tariffs is relatively simple as they imply higher prices and lower demand, calculating the net impact over the next one to two years is never easy. We think investors can analyze the problem from two important angles: i) what does it mean for the Canadian economy, and ii) what does it mean for their global investment portfolios, which is largely driven by the implications to the U.S. economy.
Canada: more bruises, but no economic knock out
Bracing for impact
Talks and fear of Canada entering a recession are valid as odds of a sharp economic slowdown are increasing, but the negative impact of tariffs is likely to be more drawn out than a sudden economic collapse. The Bank of Canada recently revisited its estimated impact of tariffs on the Canadian economy (Read: Evaluating the potential impacts of US tariffs - Bank of Canada) with a prolonged effect that spans a couple of years, with ultimate compounded result of approximately 4% of GDP. While such scenarios are useful benchmarks to consider, the outcome depends crucially on the policy response.
The direct impact of tariffs is to hit manufacturing activity, but this sector of the economy now represents less than 10% of the overall economic activity for Canada, shrinking from about 22% back in 20001. Manufacturing weighs more heavily in the province of Ontario where the auto sector is concentrated. The indirect impact is more difficult to quantify, but we can expect some spillovers, most notably for business investments as firms reassess their supply chains and productions plans, and potentially reducing or freezing their workforce.
The cavalry to the rescue
In terms of mitigating factors, the first one to note is the currency. The Canadian dollar has depreciated by almost 10% since the beginning of 2024. This leaves exporting firms better positioned to partially handle tariffs. Because markets are still unsure whether tariffs will be maintained at those level for foreseeable futures, we suspect the loonie could lose more ground to the U.S. Dollar if tariffs were sticky and thereby began damaging the economy.
The second mitigating factor are Bank of Canada (BoC) rate cuts. With a policy rate sitting at 3%, we think the BoC could quickly cut its policy rate by 100-200bps to pre-emptively offset the tariff pain. While markets have begun repricing for a more aggressive BoC policy path in 2025, we think we could see deeper and faster rate cuts if tariffs were maintained at 25% (and 10% on energy) by the summer (see chart 1). This would then also weigh on the loonie in the event the Fed holds fast to market expectations of one to two 25bp cuts for this year as the relative differential of monetary policy remains the crucial driver of the loonie (see chart 2).
Third, we think fiscal policy will respond to firms needing emergency funding to help them adjust to the trade turbulence. A combined Federal and provincial policy response of 1-2% of GDP cannot be ruled out, in our view.
Lastly, we are also expecting firms to partially absorb tariffs via a hit to profits, especially during the initial phase where both the policy and demand outlook is difficult to evaluate. We think firms will take some time to reassess the outlook given the fluidity of Trump’s policy agenda. We expect to see a slowdown in business investment in Canada even in the event of a trade deal, we suspect business confidence to remain warry of U.S. policy during the upcoming four years of the Trump administration.
This means there will be intensifying pressure on Canadian economic policies to operate a 180-degree shift and adopt business and investment friendly policies to foster a more competitive business environment for Canada.
On net, Canada is facing a challenging growth outlook with rising odds of recession during the next 12-18 months if tariffs are maintained at the punitive 25% level. Meanwhile, tariffs might cause inflation to continue biting and further reduce an already weak purchasing power. For Canadian equities, the direct hit of tariffs is limited within the constituents of the TSX, we therefore think the bulk of the negativity on Canadian equities is largely a byproduct of fear of further weakness for the loonie and the broad spillover effects that could torpedo the economy into a recession.
Chart 1: Market-implied expectations for Bank of Canada overnight policy rate
Source: Bloomberg, BMO GAM, as of February 3rd, 10:30AM
Chart 2: More “emergency” BoC rate cuts in response to tariffs = weaker loonie
Source: Bloomberg, BMO GAM, as of February 3rd, 10:30AM
United Stated: can the economy remain exceptional?
U.S. exceptionalism has been a key theme for markets in the past couple years, defying expectations of recessions and refusing to land with real Gross Domestic Product (GDP) still growing at the brisk, unmatched pace of nearly 3% year on year. Similarly, U.S. growth expectations have been trending up for over two years now (see chart 3). While tariffs might shave the U.S. growth outlook a bit, our view is that it will be small, likely no more than half a percentage point. With growth expected to run at 2.2% for 2025, we don’t think investors have to worry about the U.S. growth outlook because of tariffs. While inflation is widely expected to tick up on tariffs, we would expect the Fed to be more cautious with further rate cuts if the trajectory of the economy and labour market remains robust.
Chart 3: Cumulative revisions to consensus estimates for 2023, 2024, 2025 U.S. real GDP growth
Source: Bloomberg, BMO GAM, as of January 25th 2025
Portfolio Implications and Outlook: greater uncertainty offers cautious opportunities
Our flagship ETF portfolios were already underweight to neutral Canada since the prior month, and on Friday, bought puts on the TSX, providing a welcome downside buffer. We were also already slightly long duration2 in our Canadian bond position, which could continue to benefit from further rate declines should the BoC accelerate rate cuts. Our overall overweight of equities still stands, biased to the US, although our recent House View deliberations were leaning to fade our prior level versus last month, mostly based on expectations of rising market volatility3 and stretched valuations among tech mega-caps. Our portfolio tilts toward U.S. Banks has been the biggest boon, as steeper yield curves4 typically benefit financials. Similarly, Healthcare has seen some upside over the past few weeks, while Utilities and Staples have underperformed as defensive plays. Gold has also provided a buffer, despite the strength of the USD. On the loonie, we began very small hedges of USD back to CAD when it slipped below 70 cents, and we are looking to increase that should it get weaker.
Insights
Sources
1Source: Statistics Canada, October 2024.
2Duration: A measure of the sensitivity of the price of a fixed income investment to a change in interest rates. Duration is expressed as number of years. The price of a bond with a longer duration would be expected to rise (fall) more than the price of a bond with lower duration when interest rates fall (rise).
3Volatility: Measures how much the price of a security, derivative, or index fluctuates. The most commonly used measure of volatility when it comes to investment funds is standard deviation.Standard Deviation: A measure of risk in terms of the volatility of returns. It represents the historical level of volatility in returns over set periods. A lower standard deviation means the returns have historically been less volatile and vice-versa. Historical volatility may not be indicative of future volatility
4Yield curve: A line that plots the interest rates of bonds having equal credit quality but differing maturity dates. A normal or steep yield curve indicates that long-term interest rates are higher than short-term interest rates. A flat yield curve indicates that short-term rates are in line with long-term rates, whereas an inverted yield curve indicates that short-term rates are higher than long-term rates.
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