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June 06, 2025 | 14:00
A Tale of Two Economies
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A Tale of Two EconomiesAmerica’s global tariff war was expected to hurt the Canadian economy more than it hurt its own economy. It’s happening. |
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There is a saying that no one wins in a trade war. But the combatants can be impacted disproportionately, which is likely the case in the current conflict between Canada and the United States. Although America is waging a global tariff war, Canada’s bilateral battle should cause relatively more domestic economic casualties. Canada’s economy is more exposed to U.S trade than the U.S. economy is exposed to global trade. Goods exports to the U.S. are 19.3% of Canadian GDP (2024). And the overall economic exposure to U.S. trade is even higher given the amount of business investment tied to it. Canada is also retaliating with limited tit-for-tat tariffs, so purchasing power erosion is weighing as well. Goods imports from the U.S. are 16.0% of GDP, but the government is purposely limiting the scope of its tariffs to minimize the inflation impact. Meanwhile, purchasing power erosion is the main channel through which America’s tariffs on Canada and nearly all other nations affect the U.S. economy. Goods imports are 11.5% of GDP, with most imported products now sporting tariffs thanks to the 10% universal levy, which remains in place for the time being [1]. Weaker exports are also a channel, but the U.S. dollar has been trending weaker, augmenting U.S. trade competitiveness, when it was presumed that the currency would strengthen owing to tariffs. And, so far, only China and Canada have retaliated noticeably. Goods exports average 7.0% of U.S. GDP, with those destined for Canada (America’s single largest foreign market) at 1.5%. Note that trade policy uncertainty is another channel through which the tariff war could be negatively impacting the U.S. economy. Looking at tariffs in effect, America’s trade war started in February with the 10% fentanyl-related tariffs on all Chinese goods and with China retaliating in a limited fashion. Canada (and Mexico) entered the war in March, with fentanyl-related tariffs initially set at 25% (10% for energy and some raw materials), which were quickly scaled back to cover only goods not compliant with the USMCA. Canada was also hit in March by the 25% tariffs on steel and aluminum. Canada retaliated in both cases (25% on about $60 billion of U.S. goods). The trade war peaked (so far) in April as the 34% reciprocal tariff on most Chinese goods morphed via tit-for-tat retaliation into 125% bilateral duties. This was reduced on both sides to 10% in May. And the trade war began escalating again in June with the 25% tariff on steel and aluminum doubling to 50%. Before we investigate how this four-month, oscillating-in-intensity trade war is being reflected in the economic data, it should be noted that there could be delays before the impacts of tariffs are revealed meaningfully via changes in prices, sales, and production. Duties on final consumer goods should see impacts quicker than those on intermediate goods and production inputs. And the impacts themselves could be dominated by other economic developments. Moreover, the Administration’s erratic application of tariffs could cause delays as businesses wait to make changes until things seemingly settle down. Indeed, the postponement of hiring and capital spending plans until the tariff picture clarifies should itself have negative economic consequences (on both sides of the border). And, as we saw, business and consumer behaviour can change in anticipation of tariffs, via pulling forward spending plans (causing even lower spending later as tariffs come into effect) and stockpiling (causing impact delays as non-tariffed inventories are drawn down). |
The data paradeIn 2025 Q1, Canadian real GDP expanded at a 2.2% annual rate, but the U.S. economy contracted 0.2% (Chart 1). On the surface, the former didn’t live up to the narrative of relative underperformance. However, the figures were greatly influenced by tariff front-running. In the U.S., goods imports surged to a record high, causing a record goods trade deficit, and lopping a whopping 5.0 ppts from the GDP growth tally. Much of these imports ended up in inventory, which added 2.7 ppts to the tally. Ignoring the vagaries of trade and inventory flows, final domestic demand expanded 2.0% annualized. Despite being a nine-quarter low (so underlying growth does appear to be slowing), this was still a respectable result. |
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Canada was a beneficiary of America’s front running and had some of its own such behaviour. Higher goods exports added 2.4 ppts to Canada’s GDP growth tally. Meanwhile, imports subtracted almost the same amount (2.3 ppts), although this was tempered by an outsized drop in services imports, and inventories added 1.4 ppts. In turn, final domestic demand was essentially flat (it contracted -0.1% annualized). The April trade figures were released this week. The nominal U.S. goods trade deficit was chopped from the record US$162 billion in March to US$87 billion, as imports plummeted 20% m/m (also a record) and exports increased. In Canada, the goods trade deficit widened to a record |
Also released this week were the S&P Global PMIs (Chart 2). Activity in Canadian manufacturing and services has been contracting for most of the year. The pace of contraction has slowed from recent lows (in April and March, respectively), with the manufacturing PMI ticking up to 46.1 and the services index at 45.6 in May. But these are still bad results. Activity among U.S. businesses, in contrast, has remained at or above the 50-mark (denoting expansion) since January for manufacturers—and since February 2023 in the services sector. Both sectors pointed to a faster pace of expansion in May, with the manufacturing index rising to 52.0 and the services PMI up to 53.7. So, no marks yet from the trade war, although the two ISM PMIs dipped below the 50-mark in the month. Finally, released this week, were the employment reports for May. Canadian jobs increased by 9k, the fourth month in a row of single-digit or negative results (Chart 3). Indeed, a net 15 jobs were lost during this period. This is the weakest such performance since the pandemic period (January 2021). With the latest reading, alongside a close-to-trend 35k gain in the labour force (and the trend is slowing gradually with the new immigration limits), the unemployment rate rose a notch to 7.0%. This is the highest level since the summer of 2021. It’s interesting that the jobless rate had been trending higher through 2023 and 2024, despite decent job creation, as the latter couldn’t keep pace with the labour force (rapid population growth). Now it’s drifting up again as job growth is ebbing amid more stubbornly slowing labour force growth. Meanwhile, U.S. jobs increased by 139k in May, a bit below the prior month’s pace but above the Q1 readings. And the unemployment rate was 4.2%, in line with its longer-run (full employment) level for the third straight month. So, again, no marks yet from the trade war. Bottom line: The narrative of the Canadian economy underperforming owing to its high exposure to U.S. trade, as America wages a global tariff war, is unfolding. Meanwhile, the evidence of the U.S economy succumbing to its own trade war is scant. As noted above, there are many reasons why it might take time for economic casualties to emerge. We’ll just wait and see. With notes from Shelly Kaushik |
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[1] The U.S. Court of International Trade ruled on May 28 that tariffs levied under the International Emergency Economic Powers Act (IEEPA) were unlawful. These included the 10% universal tariff, the postponed reciprocal tariffs on 57 countries/regions, and the fentanyl-related tariffs on China, Mexico, and Canada. The ruling was appealed, with the appeals court allowing the above tariffs to remain in place until the appeals process concludes. This issue seems destined for the Supreme Court. [^] |