Focus
December 06, 2024 | 13:35
25% Tariffs: What If?
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
25% Tariffs: What If?We judge that a 25% tariff could pull Canadian growth down by nearly 2 ppts and weigh on the loonie, but monetary and fiscal policy would not stand still. |
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The November 25th threat by Donald Trump to impose 25% tariffs on all goods entering the U.S. from Canada and Mexico as of his first day in office has been largely shrugged off by financial markets. Within a week, the Canadian dollar and Mexican peso had recovered most of their initial losses, while the TSX managed to continue climbing to new record highs—hardly the response one would expect if serious economic damage loomed large. Canadian bond yields have come down heavily in the past two weeks, although much of that can be attributed to a rally in Treasuries, as well as soft domestic GDP and unemployment prints. On balance, it appears that the market simply does not take the tariff threat seriously, or that it does not represent a major step up from previously expected protectionist leanings by the incoming President. |
While we are reluctant to question the market’s wisdom, that calm response seems surprising, given the very direct nature of the threat, and as the proposed Cabinet is full of names with serious protectionist leanings. At the very least, it is a worthwhile exercise to dig more deeply into how such tariffs could affect the Canadian economy, and what the market response may be in the event. We recognize that there is a huge range of potential outcomes and questions: Are there any exemptions (e.g., energy, or auto parts)? Does it get scaled back (e.g., 10%), or even reversed at some point? Do Mexico and Canada retaliate, and to what extent? Do other economies get swept up, with possibly even harsher tariff rates? The analysis below considers the economic impact under the full 25% tariff, with only limited retaliation from Canada. The AssumptionsMonetary and fiscal policy would not stand still if Canada’s economy was faced with such a serious threat. The Bank of Canada would ultimately deliver much more interest rate relief than under a status quo backdrop. While it may not all come in one fell swoop, we suspect that the Bank would cut by at least an additional 100 bps beyond relief already in train, taking the overnight rate down to 1.50% (compared with 3.75% now), and may move faster than our current call. This could mean that the Bank would deliver a cumulative 350 bps of rate relief within the space of a year (i.e., since rates began falling in June/24). |
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Fiscal policy would no doubt be loosened as well, with the federal budget for 2025 aimed squarely at supporting the domestic economy and providing some relief for exporters. Measures could also be taken to address some of the U.S. concerns, such as border security or increased defence spending. On balance, it would be little surprise to see net new support of roughly 0.5% of GDP (or about $15 billion). We suspect that the (already loose) fiscal guidepost would be temporarily cut free to deal with the extreme situation. In this environment, the Canadian dollar would weaken markedly. While this could aggravate and even inflame some inflation pressures, we suspect the Bank of Canada would view the downside growth risk as much more meaningful to the outlook. Given a much wider Canada/U.S. short-term rate differential, as well as the deeply sour outlook for Canadian exports, an additional depreciation of 5%-to-10% would be entirely conceivable in this exceptional set of circumstances. Such a heavy drop would partially shield exporters from the most direct hit from tariffs. The ImpactsGrowth impact: New tariffs would be set against a backdrop of firming domestic demand in Canada in areas like housing and consumer spending, but that momentum would be countered in a hurry. We judge that the net impact on real GDP growth, without retaliation, would push above 1.5 ppts on a quarterly basis, and could carve 2025 calendar-year growth by roughly 1 ppt—we are currently at 2.0% growth for 2025 and 1.9% for 2026. |
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Given where underlying growth currently sits, a technical recession would be in the realm of possibility, most likely around mid-2025. Meantime, we assume that employment growth would slow sharply and productivity would be placed under further stress as firms adapt to the new regime. That combination would carve into corporate profits and lift the unemployment rate toward 8%, with some of the upside limited by much slower labour force growth—we currently expect the unemployment rate to drift down through 2025. Over the medium term, any clear fracture in the trade relationship would be negative for business confidence and investment at a time when Canada is already struggling with productivity-enhancing investment. Even in the interim, uncertainty over trade policy has the potential to hold back business investment just as interest rates are coming down, pushing more of the expansion burden onto housing and interest-sensitive consumer spending—not a great outcome. Inflation impact: The inflation picture is somewhat clouded by offsetting factors. In the very short term, Canada likely sees at least a modest inflationary impulse from a sudden depreciation of the Canadian dollar, and some firms passing on some margin pressure to domestic consumers. Keep in mind that, in theory, the brunt of the inflation impact would be absorbed by consumers on the U.S. side of the border—but we highly doubt that things will play out that way. Further out on the forecast horizon, the disinflationary impact of weaker growth and a higher jobless rate would ultimately outweigh the early inflationary impacts. A scenario where Canada retaliates with its own tariffs would be more inflationary and allow less room for the Bank to cut rates. Industry impact: Energy exports were Provincial impact: Direct exposure to U.S. trade varies across the country. B.C. carries a relatively low share of goods exports in its economy, and roughly half of those exports are destined for markets outside the U.S. That leaves U.S. exports to weigh in at just 7% of B.C. GDP, the lowest share in Canada. Alberta, Saskatchewan and New Brunswick, because of hefty energy exports, carry the largest shares at 25%-to-36%, so a lot hinges on whether tariffs would in fact be all-encompassing (we’d view energy as relatively low likelihood). Drilling down further, non-energy U.S. export exposure is highest through Central Canada. In Ontario, for example, U.S. goods exports top 17% of GDP with a wide range of industries (e.g., autos, machinery, metals and consumer goods) carrying shares in excess of 1% of GDP. Uncertainty weighs here as well, particularly for autos, where the supply chain is deeply integrated across the border. Ultimately, the regional impact of tariffs will depend on if there are any carve-outs but, setting energy aside for now, Central Canada and parts of Atlantic Canada look most exposed. |
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