Global Markets Commentary: Off to a good start – until it wasn’t

 

“Geography has made us neighbours. History has made us friends. Economics has made us partners. And necessity

has made us allies.”

 

— John F. Kennedy, 35th U.S. President, address to Canadian Parliament, May 17, 1961

 

January’s positive start to the year is now in jeopardy after the U.S. launched a trade war. Tariffs on China are going ahead, but Canada and Mexico have been given a temporary reprieve. The level of uncertainty remains elevated and headlines can rattle the markets at any moment.

 

Our advice is to remain calm. Panicked, knee-jerk reactions to any market calamity are never the best course of action. A measured reaction is especially appropriate given the pace and fluidity of the current situation.

 

Global equity markets made it through January in the green. Non-U.S. markets (yes, the ones threatened with tariffs) outperformed U.S. equity markets. The S&P/TSX Composite rose 3.3%. The Euro Stoxx 600 Index rose 8% while the S&P 500 rose 2.7%. Mexico, the other member of President Donald Trump’s 25% “circle of friends,” saw its equity benchmark climb 3.4%. Businesses, consumers, currency, stock, and bond markets react with the requisite amount of uncertainty to any shock. This situation has a unique layer of additional ambiguity that calls for extra vigilance against emotional reactions. Is this still just a negotiating tactic? What legal challenges will be launched? What influence can public or corporate backlash have on the situation?

 

Wasn’t it all supposed to be a bluff?

Given Mr. Trump’s penchant for striking deals, the self-damaging reality of the tariffs, and the weak arguments that Canada deserved punishment (despite this country’s recent and significant responses on drugs and the border), expectations were high the President would declare some form of victory and back down on the tariffs. We saw this happen in the recent reversal of the Colombian tariff threat. Mr. Trump’s follow-up announcement of a 30-day tariff delay also points in this direction.

 

The self-inflicted wounds of the tariffs could be seen as a necessary follow-through on campaign trail promises. If President Trump believes the world isn’t taking him seriously, he may feel backed into a corner. Not only by allies on trade, but by everyone on everything – China, Russia, Iran, with Panama and Greenland watching. The goal might be to strike enough fear in the minds of others so that a short North American trade war would be all that is necessary. This could explain the roller coaster of the last week and his extreme position of intransigent non-negotiation, fanned with flip-flops up to the eleventh-hour. The President, who is known to heavily weigh the opinion of the last person in the room, doesn’t yet have a full cabinet. Up to this point, some of his unconfirmed cabinet selections have been less hawkish on trade. There were recent overtures that tariff threats against Mexico and Canada were de escalating; leaks indicated that some staff were hoping to water down the timing and scope. Hawkish voices can be most influential one day, with more rational heads prevailing on another.

Is this legal? Don’t we have a free trade agreement?

Mr. Trump’s justification for the tariffs is not trade based per se. He has said the intent is to stop illegal immigration and fentanyl coming from Mexico and Canada. The USMCA does not remove the President’s authority to invoke actions under other U.S. laws. The President is using the International Emergency Economic Powers Act (IEEAP). Here, there are two theories. First, this is simply a ruse to get the tariff cash. The new administration has talked about tariffs bolstering the nation’s finances as they cut income taxes; including your number one and two trade partners does move the needle. Perhaps it is truly about the border. Canada and Mexico achieved the delay with promises to mitigate the border issues to the President’s satisfaction. It is unclear which of these fundamentally motivates the President. However, if tariffs are actually about the border, or the consequences outweigh the revenues as many economists argue, it does leave the door open as a face-saving off-ramp on some, or a majority, of the tariffs. There is also the option for a decoupling of tariff policy between Canada and Mexico, especially since the scope of the drug and migrant problem differs substantially between the northern and southern border.

 

Second, blanket tariffs are a unique and largely untested use of the IEEPA law. If tariffs proceed we expect legal challenges from various industry groups. If the tariffs are a cash grab, the courts should see the facts on trade, trade balances, and border security come to light versus the varied and false claims loudly espoused thus far. Legal challenges could have a similar effect as the courts overturning the spending freeze, which put the Trump administration’s actions on ice, at least temporarily. Many executive actions during Trump 1.0 were wrestled down via the judicial arm of the U.S. – constitutionally on par with the executive and legislative branches of government. Over time, if the courts find that IEEPA cannot be used in this fashion, the tariff risk goes down meaningfully. We have seen how capital markets are able to adjust to the fluidity of this environment. The gyrations have been as expected, depending on the headline, but market moves were orderly given the level of uncertainty.

Where are the voices of Americans who will be hurt by this?

Market participants understand the facts. This contrasts to many incorrect and blatantly false statements coming from parts of the Trump administration about who pays and who benefits from tariffs. Reactions from capital markets should serve as an important feedback loop that can influence the U.S. to see the folly of its ways. The S&P 500 weakened in late January and through the thick of the tariff threats. This oft-quoted barometer of the President’s success is signalling disapproval.

 

Beyond stocks, corporate America will be facing the truth. Analysis by Strategas Research suggests that the tariffs are the equivalent of an increase of approximately 10% in the U.S. corporate tax rate. The scale of these new tariffs is much larger than the 2018-19 tariff increases on China. Those tariff increases were roughly US$30 billion per year. The just-announced tariffs are estimated to be as much as five times larger (US$150 billion). U.S. businesses pushed back then, and the Trump administration made changes and exceptions.

 

Trade lawyers on both sides of the border have been engaged with businesses for months, ramping up tactics to appeal to any exemption process that may arise. The U.S. aluminum industry is already urging the President to exempt Canada from tariffs. The Wall Street Journal lambasted the U.S. administration for starting the “dumbest trade war in history.” Hundreds of economists signed an open letter in the WSJ highlighting “…our belief that broad-based tariffs will impede economic growth, risk triggering a trade war, and inflict longterm harm on the economy.” They urge “Congress not to adopt the administration’s proposed tariffs and urge the president not to implement those tariffs by executive order.” Key players in the automotive sector are warning of plant shutdowns and halted production. Inflationary supply shocks are coming once again. They will run at cross purposes with a Trump election promise to quell inflation. Given more than half a century of ever-increasing economic integration, if tariffs do come and last more than a few months, the U.S. will feel the impacts of a trade war with its neighbours.

Implications for investors

Canadian dollar

The Canadian dollar has already depreciated around 10% since January 2024, and spiked as high as C$1.48 at the height of the uncertainty. The currency is an important offset of the tariff impact for some, allowing Canadian exporters to lower prices as they end up with more Canadian dollars after converting the U.S. dollars received.

Equities

Tariffs are a tax and a drag on economic growth. Furthermore, the insecurity of it all impacts the animal spirits of capitalism. For investors, parsing out the combined impacts on corporate earnings is the bottom line. Far too many unknowns prevent us from drawing any detailed conclusions, but directionally, the impact is negative. However, global equity markets enter this period of uncertainty on decent footing. Earnings growth expectations are solid and recent reports are surprising to the upside across much of the world. Valuations in non-U.S. equity markets aren’t overly onerous; some are quite low (China). Tariffs are a disruption, which has been the name of the game for the last five years or more. Corporations have become quite skilled at navigating challenges, particularly supplychain snarls, including the 2018 trade war, COVID shut down and reopening, and the war in Ukraine. Add cracks in the U.S. banking system (Silicon Valley Bank failure), inflation’s spike and retreat, and a coordinated tightening cycle from global central banks. All of this has made businesses hardened, more resilient and better able to meet this new challenge.

Bonds

On January 29, the Bank of Canada cut interest rates, but this time by a just a quarter-point to bring the overnight rate down to 3%. Generally acknowledged as the world’s most aggressive rate-cutter, the BoC kept its streak going for a sixth consecutive meeting. Planning to cut more this year, our central bank decided not to wait (correctly, in our view). Trade threats were already weighing on business and consumer sentiment. Bond yields reacted as expected during the episode and fell meaningfully (bringing important price appreciation to balanced portfolios). They were responding to the demand for safe-haven investment, the prospect of an economic slowdown, and expectations of accelerated BoC easing.

Our strategy – Balanced, with an equity bias

We continue to follow our disciplined and patient approach. We are overweight in U.S. and Canadian equities. We remain neutral in our international developed markets (Europe and Japan) and emerging market equity allocations. As the equity market rallied, we trimmed our equity overweight to ensure it remained appropriately sized, with proceeds deployed in safer capital preservation assets.

 

Our U.S. asset exposure is predominantly U.S. equities, with some in fixed income and alternative assets. All are unhedged from a currency standpoint. While these investments are compelling on their own merits, the U.S. dollar exposure provides a lift to portfolios for Canadian investors at a time when the loonie is under pressure.

 

The Canadian stock market is not the Canadian economy. Tariff threats conjure up images of steel, forest products, food stuffs and auto parts. While these are important to the Canadian economy, their weighting on the Canadian stock market is minimal. These industries combined are a low-single-digit weight of the S&P/TSX. The big weightings are metals and mining at 12%, energy 17%, and financials 33%. These sectors are, of course, important to the Canadian economy, but they have an outsized footprint on the S&P/ TSX. Resource companies are seeing a lighter tariff impact; financial services face none.

 

Notably, many Canadian companies in industries subject to tariffs have significant plants, facilities and operations inside the U.S.; none of these are subject to tariffs.

 

We see Canadian medium- and longer-term bond yields falling, bringing price appreciation to our highest-quality bond positions. This is the role these bonds play in our balanced portfolios.

The last word – No knee-jerk reactions

Equity markets have an historic ability to weather external shocks, including wars, terrorist acts, pandemics and other assorted economic calamities. President Trump says he wants a golden age for America; many would argue the U.S. was in a golden age when JFK was President.

 

We can expect sharp reactions in the short term as new information is assimilated into valuations and outlooks, but it is important not to let fear or emotion drive decision-making. Our advice is to remain calm. As always, the best defence against bouts of market volatility is our approach, which is to maintain a well-diversified portfolio across asset classes, sectors and individual issuers.

 

Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.

 

 

BMO Private Wealth is a brand name for a business group consisting of Bank of Montreal and certain of its affiliates in providing private wealth management products and services. Not all products and services are offered by all legal entities within BMO Private Wealth. Banking services are offered through Bank of Montreal. Investment management, wealth planning, tax planning, philanthropy planning services are offered through BMO Nesbitt Burns Inc. and BMO Private Investment Counsel Inc. If you are already a client of BMO Nesbitt Burns Inc., please contact your Investment Advisor for more information. Estate, trust, and custodial services are offered through BMO Trust Company. BMO Private Wealth legal entities do not offer tax advice. BMO Trust Company and BMO Bank of Montreal are Members of CDIC.

^® Registered trademark of Bank of Montreal, used under license.