Why Terminating NAFTA Would Be Painful For Everyone

Last update on Sept. 4, 2017.

Image Credit: George Rudy/Shutterstock.com

 

At the beginning of every month, I brief members on how MoneyGeek's Regular portfolios have performed and comment on the state of the financial markets. In this update, I’ll also explain why terminating trade agreements tend to hurt economic growth.

 

Aug Performance of Regular Portfolios

The performance of MoneyGeek's Regular portfolios for the month of August 2017 were as follows:

 

Last Month

Last 12 Months

Since Apr 2013

Slightly Aggressive

+0.5%

+10.9%

+77.6%

Balanced

+0.5%

+9.6%

+64.7%

Slightly Conservative

+0.5%

+8.3%

+52.4%

Moderately Conservative

+0.4%

+6.9%

+40.7%

Very Conservative

+0.4%

+5.6%

+29.7%

I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Regular Slightly Aggressive portfolio.

 

Last Month

Last 12 Months

Since Apr 2013

RBC Select Aggressive Growth

+0.6%

+7.7%

+55.4%

TD Comfort Aggressive Growth

-0.1%

+5.7%

+42.0%

CIBC Managed Aggressive Growth

+0.8%

+6.7%

+48.3%

Canadian Couch Potato Aggressive

+0.7%

+10.1%

N/A

In contrast to our competitors, MoneyGeek’s Regular portfolios employ stocks/ETFs that follow the value investing strategy (QVAL, IVAL and BRK-B), and also allocate a larger percentage of the portfolios toward Canadian oil and gas stocks (XEG.TO) and gold (CGL-C.TO). If you would like to take a look at our portfolios, I invite you to sign up for our free regular membership.

The Regular portfolios slightly underperformed our competitors in August. While CGL-C.TO went up by 4.2% due to worries about potential geopolitical conflict, XEG.TO went down by 3.9% because of hurricane Harvey’s disastrous effects on oil infrastructure.

Meanwhile, the Canadian economy continues to post impressive growth. According to Statistics Canada, the Canadian economy grew at an annualized rate of 4.5% from April to June of this year. Yet the Canadian stock market has barely budged this year. The TSX Total Return Index, which measures the Canadian stock market performance, including the effect of dividends, has barely moved from 49,874 at the beginning of the year to 49,893 on Aug 31.

There are many reasons the Canadian stock market has been lackluster, but one reason could be investors’ anxiety over the North American Free Trade Agreement (NAFTA). NAFTA promotes free trade between the U.S., Canada and Mexico by largely eliminating tariffs between the three countries. Since taking office, Trump has made trade a priority for his administration, and has started the process of renegotiating the deal. In addition, he has stated multiple times that he wants to eventually terminate the deal altogether.

Most economists believe terminating the deal would have negative consequences for the economies of all three countries. But I don’t think many non-economists understand why, so I thought I’d explain the rationale using a simple example.

 

Why Reducing Trade Hurts Everyone

The most common Canadian export to the U.S. in 2016 was vehicles, so let’s assess the impact that terminating NAFTA would have from the point of view of the American consumer who wants to buy a car.

Suppose that our American consumer has a budget of $30,000 to buy the car, and the car that she wants happens to be manufactured in Canada, which has a price tag of $30,000. As it currently stands, the consumer would then happily purchase the car, and $30,000 would go towards the Canadian factory that manufactures the car. The factory would then pay $25,000 of the revenue to a worker to keep him employed for another 6 months.

Now, let’s say the Trump administration terminates NAFTA and puts a tariff of 10% on all cars manufactured in Canada. If that happens, then the price of the imported car would go up to $33,000, and our American consumer will no longer be able to afford the car. The Canadian factory producing cars will generate lower sales as a result, and may have to lay off a worker manufacturing the car. This is obviously bad for the Canadian economy.

Those who support terminating NAFTA understand all of this. But they also argue that any jobs lost in Canada will come back to the US. Unfortunately, this is not always the case.

If a car company sets up a factory in Canada, that’s usually because they believe Canada’s the cheapest place to manufacture cars. If the company could manufacture cars for say, $29,000 in the US, they would have set up the factory in the US in the first place.

After the termination of NAFTA, the price of importing cars to Canada may become expensive to the point that it makes sense to set up a new factory in the US. But the cost of manufacturing each car in the US may be higher, such that the company has to charge $31,500 for each car, which is still outside the budget of our American consumer. Absent the purchase, the car company may not build the factory in the US, and the new job may never materialize.

On the other hand, if the American consumer can’t get her first choice car, she will probably resign herself to getting a lower quality car. If the lower quality car is manufactured in the US, buying that car would lead to higher revenues for the factory, who may then hire more American workers, right? Not necessarily.

Remember that trade is a two way street. If American consumers buy fewer Canadian goods, then Canadians will generally purchase fewer American goods as well. The manufacturer that produces lower quality cars in the US may export fewer cars to Canada, and that may cancel out the increase in domestic demand.

In the above scenario, the result of the termination of NAFTA is that a Canadian worker gets laid off, and the American consumer ends up with a lower quality car. Nobody is happy, except maybe the government that gets to collect the tariffs.

Furthermore, an identical scenario will probably play out for American workers who create products that are exported to Canada. In that case, the termination of NAFTA may lead some American workers to be laid off, and leave Canadian consumers with lower quality goods.

I will admit that this is a rather oversimplified analogy. The real world is a lot messier, and the elimination of NAFTA could lead to unexpected outcomes. But most economists agree that reducing trade is bad for both economies in general. Unlike what some people believe, trade is not a zero sum game, where the pain of your trading partner becomes your gain. I only hope that the NAFTA negotiators understand this fundamental point.

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