Non-U.S. trade deals offset tariff impact on Canada

U.S. Fed caught between a rock and a hard place

For Canadian investors, the tariff threat remains at the epicenter of investment decisions. Prime Minister Mark Carney met with President Trump on May 6. Carney had downplayed expectations that anything concrete would come from that meeting. The idea was to reset the Canada/U.S. relationship while setting Canada’s global trading relationships with like-minded partners. Which is to say, elimination of internal trade barriers, expansion of trade with Mexico, Asia and the European Union, while restarting discussions and removal of regulatory restrictions for an east west pipeline. Something that is long overdue!

We are also seeing some green shoots from Carney’s made-in-Canada approach. Canadian companies, which tended to rely on U.S.-Canada free trade, are beginning to seek opportunities elsewhere. Most notably is a renewed interest in the trade deal between Canada and the European Union, known as the Comprehensive Economic and Trade Agreement, which was signed in 2016. A similar pact that governs trade between Canada and Britain came into force in 2021. Both agreements – which emphasize free trade and harmonized regulations – eliminate virtually all tariffs on goods and services. Not surprisingly these deals have become a welcome offset to Mr. Trump’s slapdash protectionism.

There are early signs of shifting trade patterns. Trade numbers for March showed a drop in Canadian trade with the U.S., while Canadian exports to other countries, including the Netherlands, Germany, and Britain, climbed sharply, offsetting most of the decline from exports into the U.S.

Canadian companies have also been receiving newfound support and encouragement from European leaders, who are also facing a looming trade war with Mr. Trump. Two recent European trade shows have put Canada at the forefront.

“We are with you,” German Chancellor Olaf Scholz said to the Canadian contingent at the opening of the Hannover trade fair, one of Europe’s largest. “Canada is not someone else’s federal state. Canada is a proud, independent nation.” We couldn’t have said it better!

Some Canadian companies are in a sweet spot and stand to benefit from this change in mindset. Companies such as Canadian Pacific Kansas City Ltd. (TSX: CP), which is the only railway with a transportation network that flows from Canada to Mexico. CP shares, as with all the railways, has been damaged by the tariff threat, but longer-term, the company’s exclusive north-south route should reap the rewards of increasing trade with Mexico that bypasses the elephant in the room.

U.S. Fed caught between a rock and a hard place

What comes to mind when looking at the elephant in the room – U.S. President Trump’s tariff policy – is the term “dynamic adaptability” or if you prefer plain English: “I have no idea what I’m doing, but let’s roll with it.”

The Trump Administration is staring at a short timeline with U.S. 2026 mid-term elections around the corner. Unless the U.S. economy turns up before November 2026, we will likely witness a marked shift in the political pendulum.

Unfortunately for the adults in the room, Trump’s predilection towards structured spontaneity threatens to paint the Federal Reserve Board into a lose-lose corner: Navigate a recession or manage a period of stagflation.

As expected, at the May 7 meeting of the rate-setting Federal Open Market Committee (FOMC), the data-dependent Fed decided to remain on the sidelines by keeping its overnight lending rate unchanged. The principal concern was sticky inflation and the potential risk of stagflation for which there are no effective policy tools.

The Fed finds itself between a rock and a hard place. Trying to shift policy with so much uncertainty is the classic goalkeeper’s dilemma. Dive right to address inflation by keeping rates where they are, or dive left to counter weaker growth by cutting rates.

This is not a typical economic cycle where the Fed can draw from historical precedent. There is simply no scenario that allows for a preemptive rate cut, which means the Fed will not cut rates based on soft economic data. It will need to see tangible hard data that definitively indicate slowing economic growth.

Economists are puzzled as to why the March employment and wage data did not square with the GDP growth trajectory. One possibility is the reluctance of companies to lay off workers during an economic cycle that is propelled by a misguided on-again-off-again tariff strategy.

If Trump decided to stand down before the onset of a major recession, companies would be caught flatfooted trying to restock their labor pool in a tight labor market. For most companies, it is better to maintain their current employment levels for the next six to nine months to see how the tariff strategy unfolds.

That’s a problem, and the Fed knows this. The Fed is also aware that if the employment data were to weaken, it may be late to the game, which could lead to a deeper recession.

Historically, Fed Chairman Jerome Powell has epitomized patience. His seven-year track record is to wait patiently for data confirmation, which prompts a rapid response. The seminal moment will be a marked shift in the U.S. labor market or a change in consumer spending patterns.

Sometimes, the Fed sets interest rates with a focus on maximizing good outcomes. It did this last year when it cut rates because inflation was declining. Other times, the central bank makes decisions with a focus on minimizing the worst outcomes. That was the case in 2022-23. Back then, it hiked rates aggressively, risking a recession, to prevent high inflation from becoming entrenched.

According to The Wall Street Journal, “tariffs could force them into the latter course. Taxes on imports could push up prices in the short run while the uncertainty generated by their abrupt implementation could slow economic activity, delivering a whiff of stagflation. The risks of higher prices could make the Fed reluctant to preempt economic weakness by cutting rates. Instead, officials could focus initially on making sure a one-time rise in prices doesn’t fuel more-persistent increases.”

We agree with that assessment. The question is how decisively they will respond if concrete evidence of a deteriorating job market emerges. The case for cushioning the economy with lower rates would build as unemployment rises.

Richard Croft is Founder, Chief Investment Officer, and Portfolio Manager of R.N. Croft Financial Group Inc.

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