Market Brief: Trade Shock Roils Global Markets

The dollar is climbing, yields are rising and equity markets are setting up for sharp losses at the open after US President Donald Trump fired the opening salvo in what could quickly devolve into a global trade war.

The administration said Saturday it will levy 25 percent import taxes on goods from Canada and Mexico—with Canadian “energy resources” subjected to a lower 10 percent levy—along with an extra 10 percent tariff on imports from China. If implemented immediately and sustained, this would represent the biggest increase in duties since the Smoot-Hawley Tariff Act of 1930—often blamed for deepening the Great Depression—and the largest single-year increase since the 1861 Morrill Tariff—which significantly worsened political strife in the years leading up to the Civil War.

“Retaliation clauses” were inserted into the executive orders laying out the action, suggesting that the US could increase tariffs further if other countries respond with protectionist actions of their own. But leaders in Canada and Mexico—responding to game theory logic as well as domestic constituencies braying for reprisal actions—both said they would hit back at US exports. Canadian Prime Minister Justin Trudeau said Canada would apply a 25 percent duty to US products that will be phased in over the next three weeks, and Mexican President Claudia Sheinbaum authorised her finance minister to do something similar, with details set to be announced in coming days.

No one will win what the Wall Street Journal this weekend called the “Dumbest Trade War in History”. If hostilities persist, both Canada and Mexico will suffer disproportionately, with both economies likely to topple into recession within weeks. But the US economy will also take a hit, with major multinationals experiencing operating margin compression, consumers dealing with higher costs, and investors grappling with substantially higher levels of uncertainty as countries rush to apply new levies against each other. There’s no reason to imagine that the directional impact on US exports will differ materially from the negative shock that was experienced after a similar escalatory cycle got underway in the early 1930’s.

Markets aren’t panicking. The selloff has been relatively restrained, likely reflecting a widespread belief—one that we share—in Trump’s willingness to de-escalate once Trudeau and Sheinbaum offer concessions that can be presented to the media as a victory. Trump has a long history of making outrageous threats only to back down once symbolic displays of obeisance are performed by foreign leaders, and it is possible that this time is no different: the president is scheduled to speak with both leaders in the coming hours, and the next set of headlines could deliver upside gains in financial markets.

But we worry that market assumptions—and our own—amount to hopeful self-delusions. The reasons Trump has presented for implementing tariffs simply don’t hold up in reality: vanishingly-small volumes of fentanyl are smuggled from Canada (frankly speaking, Canadian production is uncompetitive from a cost perspective), migration flows are relatively minor (and go in both directions), and the country runs a trade deficit with the US in the same manufactured goods categories that the president wants to reshore. There’s little evidence to suggest that tariffs can address fentanyl shipments to the US, weakening the Mexican economy—while also taking aim at countries like Panama and Venezuela—will only increase the flow of migrants heading north, and trade between the two countries is surprisingly balanced. It is surprising, given the political optics, that energy resources were tariffed, and it’s simply not possible to replace income taxes with trade levies in funding the US government, even if Elon Musk succeeds in making a major dent in spending levels. It is therefore possible that Trump is motivated by other factors that cannot be easily resolved through agreements with foreign capitals.

If no disarmament agreement is achieved before tomorrow, cross-border businesses across North America could experience a level of chaos not seen since the onset of the coronavirus pandemic in 2020. To our knowledge, detailed guidance on implementation—affected product codes, rules for intermediary products and multi-stage manufacturing flows, remediation mechanisms, etc.—has been lacking thus far, meaning that there will be long delays at ports and border crossings in the days ahead as customs agents, businesses, and logistics providers struggle to adapt. Markets could weaken further.

Against this backdrop, economic fundamentals are unlikely to play a significant role in driving price action in the week ahead. But the US will get several updates on labour market conditions—Tuesday’s December Job Openings and Labor Turnover Survey, Thursday’s weekly jobless claims, and Friday’s January non-farm payrolls report—which should show unemployment remaining low and job creation rates holding up, reflecting continued gains in real household incomes and overall consumer spending. Canada is likely to report a reversion toward normal job creation rates in Friday’s Labour Survey report, with the unemployment rate ticking back up to 6.8 percent in January after a surprisingly-strong December print. And the Bank of England will almost certainly cut rates by another quarter point, with policymakers seeking to alleviate an economic downturn—and signs of incipient softness in the job market—while keeping a wary eye on inflation.

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