U.S. Tariff Threats: Potential Impacts on Canada

On March 4, U.S. President Donald Trump proceeded with implementing tariffs on Canada and Mexico under the International Emergency Powers Act. Imported goods from Canada and Mexico will be subject to a 25% tariff, while Canadian energy imports will be subject to a 10% tariff. U.S. imports from China will be subject to an additional 10% tariff, adding to the 10% levee last month. Canada announced retaliatory measures, with 25% tariffs on $155 billion in U.S. goods, with $30 billion in effect today, while the remainder will go into effect on March 25.*

What is a tariff? A tariff is a tax on goods imported from another country and, all else equal, increases the cost of imports, making foreign goods less competitive in the marketplace.

The economic and market impact will be determined by how long tariffs remain in place, which remains uncertain. The government's fiscal response and the Bank of Canada's monetary response to the tariff headwinds will be important drivers as well. Given the fluidity of the situation and the number of moving pieces, we recommend that investors adhere to their long-term investment strategies and resist the urge to overreact to headlines.

Nonetheless, we provide the following perspectives on the potential impact of U.S. tariffs on Canadian goods.

Impact on the economy

In our view, a sustained 25% tariff would have a strong negative impact on Canadian economic growth, potentially sending the Canadian economy into a mild recession. With Canadian goods exports to the U.S. representing roughly 20% of GDP, it is estimated that tariffs may result in a 2.5%-3% decline in GDP. Tariffs will make Canadian exports less competitive and will likely drive U.S. firms to search for substitutes. A weaker currency can serve as an offsetting factor to tariffs, as Canadian goods would become cheaper in U.S.-dollar terms. Since the U.S. election in November, the loonie has depreciated by roughly 5% against the U.S. dollar. We'd expect the loonie to further weaken against the U.S. dollar if 25% tariffs are sustained, although not enough to fully offset the impact of tariffs.

Economic growth would likely slow directly through lower exports. Additionally, there would be negative indirect effects, as lower exports could weigh on Canadian firm profitability, which could lead to lower employment, private investment and consumption. However, in this scenario the government would likely provide fiscal support to the economy, helping activity stabilize. Additionally, we'd expect the Bank of Canada (BoC) to continue easing monetary policy to help support economic activity.

Canada has more to lose from a trade war, but there would be impacts to the U.S. economy as well. According to the U.S. Energy Information Administration, 60% of U.S. crude oil imports originated from Canada in 2023. Additionally, Canadian crude oil was responsible for 24% of U.S. refinery throughput in 2023, highlighting the importance of Canadian energy products to the U.S. Across the board, tariffs on Canadian goods would lead to higher gas prices for U.S. consumers and higher input costs for corporations. The U.S. administration is aware of this possibility, which is likely why it subjected Canadian energy imports to a lower 10%.

Impact on inflation and central-bank policy

As expected, Canada announced retaliatory tariffs on $155 billion in U.S. goods, with $30 billion effective March 4, and the remainder set to take effect on March 25.* The combination of retaliatory tariffs with a potentially weaker loonie could put upward pressure on Canadian inflation, particularly goods prices.

However, we'd expect these inflationary pressures to be offset by weaker economic growth. The BoC would likely view a rise in inflation due to tariffs as transitory and continue normalizing monetary policy through interest-rate decreases. If the tariffs prove to be short-lived, we'd expect the BoC to bring its policy rate down to around 2.5% over the course of the year; however, if 25% tariffs are sustained, we'd expect the BoC to cut rates more aggressively to support economic growth and employment.

South of the border, given the heavy reliance on Canadian energy imports, tariffs on Canadian goods will likely lead to higher U.S. headline inflation through a rise in energy prices. While the Federal Reserve (Fed) targets the core personal consumption expenditures price index as its preferred measure of inflation (which excludes food and energy prices), a rise in energy prices would be unwelcome, as it can lead to higher costs down the supply chain if elevated energy prices are sustained. We still believe the bar for a Fed rate hike is high, but a 25% tariff on Canadian goods and a 10% tariff on energy imports will likely put additional Fed rate cuts on hold in the near term.

Impact on markets

While we see meaningful downside risks to the Canadian economy if 25% tariffs are sustained, the impact on the stock market could prove to be less pronounced. Approximately one-third of the revenue generated by companies in the S&P/TSX Composite comes from the United States, with the technology, industrials and utilities sectors having the highest share of U.S. revenue.* However, some of those sectors that export large amounts of goods to the U.S. have small representation in the Canadian equity market. For example, automotive components are the second-largest category of exports after oil, gas and minerals, accounting for 10% of Canada's exports to the U.S.** Yet, the industry only represents 0.5% of the TSX's total weight.* The primary companies producing and exporting these goods to the U.S. are Ford, GM and Stellantis, all domiciled in the U.S.

Conversely, many of the largest sectors in the TSX don't export physical goods to the U.S., and therefore wouldn't be directly impacted by tariffs. For example, the financials sector, which comprises roughly one-third of the TSX, would see limited direct impact from a tariff on goods exported to the U.S. However, the indirect effect of slower economic growth could weigh on broader performance over time. 

The sectors most exposed to tariffs in the near term are energy and materials. For these sectors, however, commodity prices – not tariffs – are likely to be the primary driver of performance. Trump's energy policies may have a greater influence on earnings than tariffs.

During Donald Trump's first term in office, his administration applied targeted tariffs to steel and aluminum imports in 2018, before exempting Canada and Mexico in 2019. Over this time, stock markets in Canada and the U.S. were unfazed by the tariffs, with the TSX gaining roughly 5% and the S&P 500 nearly 7% over this time. Though there was a spike in volatility and a sizable market pullback at the end of 2018, it was driven by concerns about the Fed rate hikes rather than trade.

Volatility in equity markets surged following the initial announcement of tariffs in early February and again in March. In our view, the magnitude of the announced tariffs could have a larger impact on markets than the targeted tariffs in the 2018-2019 experience. However, the fundamental backdrop remains supportive. Unlike 2018, central banks are cutting rates instead of hiking them, and both Canadian and U.S. economies are expanding while corporate profits are rising.

The bottom line

Developments on trade will be a source of uncertainty in the weeks and months ahead. However, weakness in the Canadian dollar and potential fiscal support would provide offsets, while the TSX, based on its sector composition, may not be as exposed to tariffs.  We recommend investors avoid the temptation to abandon long-term strategies in hopes of avoiding short-term dips. Historically, fear and panic have not paid off.

Portfolios that feature asset class and geographic diversification may be less susceptible to the investment risk that could arise from a trade war. We believe our opportunistic asset-allocation guidance is well-positioned for the current environment. We continue to recommend a slight underweight to Canadian large-cap, developed overseas large-cap, and developed overseas small- and mid-cap stocks, offset with an overweight to U.S. large-cap and U.S. small- and mid-cap stocks. While we wouldn't characterize tariffs as a positive development for U.S. equity markets, we believe U.S. markets are best positioned to deal with tariffs relative to Canadian or overseas equities. If you have questions about how your portfolio is positioned and how it will help you meet your personal financial goals, speak to your Edward Jones Financial Advisor.

Angelo Kourkafas, CFA
Investment Strategist

Brock Weimer, CFA
Associate Analyst