By Patrick McAllister
Trade policy and tariffs continue to dominate government, corporate, and investor mindshare. While olive branches have been extended between the EU and the U.S., the latter could look to escalate its trade showdown with China by imposing tariffs on an additional $200B worth of Chinese goods as early as September 7. The U.S. and Mexico have announced a trade agreement, but whether this is a harbinger of a revised NAFTA that includes Canada or leaves much work to be done remains subject to considerable uncertainty.
What appears to have been settled?
The rules governing tariff-free trade in automobiles and auto parts among NAFTA partners had been the largest wedge separating the U.S. and Mexico. With the deal announced on August 27, Mexico largely acquiesced to key U.S. demands and the issue of auto trade appears to have been settled.
A definitive account of what has been agreed will remain elusive until the legal text is released later this month, but the new rules have been widely reported to raise the minimum NAFTA-zone content requirements for duty-free trade to 75 percent (from 62.5 percent) and stipulate that at least 40 percent of content must come from plants at which workers earn $16 per hour or more. While details remain scant (e.g., what is the implementation timeline and how is content measured?), we believe that Canada is broadly aligned with the U.S. on the rules governing auto trade in a renegotiated NAFTA.
Where Canada may not be aligned with the U.S.-Mexico trade deal is the inclusion of a “sunset clause.” The initial U.S. negotiating position called for the inclusion of a clause that would require all three countries to agree on extending NAFTA every five years, otherwise the deal would be terminated. The U.S. and Mexico struck a compromise whereby a six-year review would be followed by a 10-year sunset in the event the review did not result in an agreement to extend the pact. While we presume the Canadian negotiating team prefers an accord without such a clause, we believe the compromise will ultimately prove acceptable.
What issues remain outstanding?
Several sticking points remain as U.S. and Canadian negotiators reconvene talks in Washington.
Headlining these issues is NAFTA’s existing Chapter 19 that allows companies that believe they have been unfairly targeted by duties to request arbitration via a bilateral trade panel. U.S. Trade Representative Robert Lighthizer views this provision as an infringement on U.S. sovereignty, but the Canadian government has been strident in calling for its preservation. A dispute settlement mechanism outside of the U.S. court system was a make-or-break issue for Canada in negotiating NAFTA’s precursor, the Canada-United States Free Trade Agreement, which prompted the Canadian delegation to briefly walk out of the 1987 talks during the debate over its inclusion. We believe a creative solution may be required that satisfies both sides and provides cover against being seen as caving on a key issue.
Canada’s dairy supply management system has been in President Trump’s crosshairs and is likely to require some movement on Canada’s part. Trade pacts negotiated with the EU and the Trans-Pacific Partnership have seen Canada accept increased dairy import quotas, but it remains to be seen if this would be enough to satisfy the U.S.
Beyond this politically sensitive file, negotiators must tackle a host of other issues including intellectual property and cultural exemptions if they hope to strike a deal.
The path forward remains highly uncertain
After striking a deal with Mexico, Trump notified Congress on August 31 of his intention to sign a new trade agreement with or without Canada within 90 days. Whether Congress will entertain a bilateral deal is an open question as the original mandate bestowed on the administration called for negotiating a trilateral agreement. With notice of intent delivered, the administration must provide Congress with the legal text of the agreement by September 30, which provides a guidepost for progress in negotiations with Canada.
We believe a lack of tangible progress by that date could see the U.S. attempt to further its bilateral deal with Mexico and/or signal its intent to withdraw from NAFTA. Either option could meet considerable resistance from Congress, the ultimate arbiter of U.S. trade, and condemn NAFTA to prolonged uncertainty.
We continue to view trade policy uncertainty as a key risk that offsets the Canadian equity market’s seemingly discounted valuation and underlines our Market Weight recommendation.
Non-U.S. Analyst Disclosure: Patrick McAllister, CFA, an employee of RBC Wealth Management USA’s foreign affiliate RBC Dominion Securities Inc., contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since he is not an associated person of RBC Wealth Management, he may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.