Trade Thoughts: NAFTA

Since August 2017, U.S. trade representatives have been renegotiating NAFTA with fellow members Mexico and Canada. The efforts have left many investors wondering, what is their objective, and where do negotiations currently sit?

The Trump administration’s primary goals are to update and rebalance NAFTA to address modern trade issues including:

• Strengthening domestic manufacturing by increasing restrictions on the country of origin of auto parts
• Preventing other countries (notably China) from using Mexico and Canada as a backdoor to import goods into U.S. markets
• Shrinking the U.S. trade deficit with Canada and Mexico

Mexico’s President-elect, Andrés Manuel López Obrador, has altered the trade dynamic since his election in July. The U.S. and Mexico are currently engaging in bilateral negotiations over NAFTA. It is still tenuous, but U.S. trade representatives have expressed optimism about reaching a deal in principle soon.

López Obrador wants to increase Mexico’s standard of living in part by enhancing the Mexican manufacturing base, for which renegotiation of NAFTA could be mutually beneficial. Also, a deal in principle could exempt Mexico from recently proposed auto tariffs much like South Korea, the third largest steel importer, avoided steel tariffs earlier this year.

While U.S. trade representatives have spoken optimistically about a U.S./Mexico trade agreement happening soon, Canada is a little trickier.

Canada recently joined the Trans-Pacific Partnership (TPP), a free-trade agreement between Canada, Australia and Asian countries not including China. With Canada’s entry into the TPP, the U.S. is at risk of the Canadian market being exploited as a gateway for non-Canadian goods into the U.S. In addition, Canada also has some concerns with U.S. trade positions.

Despite the differences, the three NAFTA members have expressed optimism for successful completion of trade talks and a three-way, tripartite agreement during 2018. If that isn’t doable, bilateral deals between the U.S. and each Mexico and Canada are another possibility. After any agreements, the Congress or Parliament in each country would have to approve the deal for it to take effect.

In ideal terms, free trade is the most efficient trade arrangement. However, free trade isn’t free unless it is fair. Thus remains the question, what do you do when those principles collide?

On average, over the last 25 years, global trade has increased by 5 percent per year. By comparison, trade is less integral to the largely self-consuming U.S. economy than it is to other countries. The U.S. exports only 8 percent of what it produces. Other economies, like China (19%), South Korea (36.5%), Mexico (35.6%), and Canada (25%), export far more as a share of GDP.

This leaves the U.S. holding the better cards for trade negotiations, but are massive tariffs the right tool to get results? To date, far more tariffs have been threatened than have been implemented. And, if results can be achieved before tariffs are implemented and settle into the economy, the NAFTA countries will be much better off.

Reflecting on what this means for investments, there is some added uncertainty in the near term due to NAFTA negotiations and tariffs. On the positive side, tax reform, repatriation, and deregulation are having a positive impact on earnings and valuations. Over the long term, diversified asset allocations should be managed with the investor’s individual risk tolerance and withdrawal needs in mind.