Best- and worst-case scenarios of Trump’s trade war

Fundata

So it’s on. The trade war we all feared but hoped would never happen has exploded. Who knows where it will end? The world has not seen anything like this since the 1930s when President Herbert Hoover signed the Smoot-Hawley Tariff Act. That set in motion a series of international retaliatory actions that slashed U.S. exports by 61% and imports by 66% between 1929 and 1933. And what did that do for the U.S. economy? Gross national product dropped 46% in that period. The unemployment rate in that country rose from 8% at the time the Act was signed to 25% four years later.

None of this has deterred President Trump and his advisors from embarking on the same protectionist journey. There are some who claim this is just an aggressive negotiating tactic by the President to get a better NAFTA deal. I don’t think so. Mr. Trump is proving to be an ultra-conservative ideologue who is doing everything he can to implement his beliefs.

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He has already indicated that he will not stop with steel and aluminum when it comes to Canada. He now has our auto industry in his sights – about 80% of the cars we build are exported to the U.S. And he recently tweeted again about how U.S. dairy farmers were being mistreated by Canada’s supply management system and took another swipe at our lumber exports. It appears there is more bad news to come from Washington, as last week’s G7 Summit in Quebec demonstrated.

Canada’s response may seem huge in our terms, but it’s a pinprick for the U.S. economy. Slapping tariffs on items as diverse as ketchup, toilet paper, playing cards, soy sauce, and inflatable boats, as well as U.S. steel and aluminum, will inflict minor pain on some U.S. companies, but it will be nothing like we are likely to experience.

So far, the markets appear to have taken all this in stride. The Dow Jones Industrial Average has been posting triple-digit daily gains, while the TSX makes steady weekly gains. But investors may be whistling past the graveyard.

Let’s consider the best and worst things that may flow from this situation.

The best-case scenario is that this is indeed a negotiating tactic that works. Here’s how it might play out: Canada and Mexico bend on their NAFTA positions, and the U.S. softens just enough to get a quick deal that satisfies the President, while leaving the other two partners with a modicum of dignity. A memo of understanding is signed within a month, the metals tariffs are revoked, as are the retaliatory measures, and life in the North American trade world returns to a degree of normalcy. I put the odds on that happening at 25% at best.

The worst-case scenario would unfold over a longer time period. In the initial stages of this scenario, we would see a decline in Canadian exports of steel and aluminum to the U.S. and corresponding layoffs in the affected industries. We would also see consumer prices begin to rise on targeted U.S. imports.

Rising prices would boost inflation, which is already close to the Bank of Canada’s 2% target and is expected to rise due to higher gasoline prices. That in turn would increase the pressure on the central bank to raise interest rates. The result would be to push the loonie higher, making our exports even less competitive and putting the squeeze on highly indebted mortgage holders.

Higher interest rates would further erode the market price of bonds, certain types of preferred shares, and interest-sensitive stocks, such as utilities and telecoms. We have seen evidence of this already. On the other hand, higher rates could boost the earnings of banks and insurance companies, provided they did not lead to widespread bankruptcies.

If the trade war becomes as nasty as it did in the 1930s, the global economy, which has become increasingly inter-dependent, will falter. Recession or even depression in many countries is the probable outcome.

As an investor, what should you do? Here are some suggestions.

Reduce exposure to Canada.We will fare far worse than the U.S. in a trade war, and growing uncertainty about the future will curtail capital investment. Apart from financial companies and the newly-revived energy sector, there are few areas of the TSX that inspire confidence. One exception: companies that do a lot of business within U.S. and are not hit by the new tariffs.

Increase exposure to the U.S.Mr. Trump has proved he is no friend to Canada (or any other ally for that matter). However, his policies have revitalized the U.S. economy, particularly the corporate tax cut and the slashing of crippling regulations. Unemployment in the U.S. is below 4%, the lowest in almost two decades, and the American stock market continues to hit new highs.

Raise cash.If the worst-case scenario unfolds, the world economy will eventually tank. At that point, you want to be in a position to take advantage of the bargains that will emerge, as they did in 2008.

We are now sailing in waters not seen in almost 90 years. There is no way of knowing how it will all turn out, but we should be prepared for anything.

Courtesy Fundata Canada Inc. © 2018.Gordon Pape is one of Canada’s best-known personal finance commentators and investment experts. He is the publisher of The Internet Wealth Builder andThe Income Investor newsletters, available through his BuildingWealth.ca website. This article is not intended as personalized advice.

 

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