In today’s article, your humble author returns to a familiar theme. Previously I wrote about the rising protectionist trend building globally for at least the past 10 years (or longer), see here. As it happens, the topic has resurfaced in light of reemerging trade tensions both between the US and Canada, and within Canada itself.
As a major exporter, Canada has greatly benefited from trade deals like the Canada-US Free Trade Agreement (FTA) and the North America Free Trade Agreement (NAFTA). Any threat to the Southward flow of goods also threatens Canada's attractiveness as an investment destination. Thus, the recent escalation of trade tensions between the US and Canada is troubling, and there are signs it could not have come at a worse time.
With the energy sector representing roughly 20% of the Toronto Stock Exchange (TSX), broad-based Canada-focused ETFs are vulnerable to both disruptions to, or bottlenecks in, the flow of oil and gas. Inter-provincial disputes over pipelines therefore represent a major sore spot for this Northern economy. Moreover, the Bank of Canada's (BoC) recent, and uncharacteristic, hawkishness at a time when the Canadian consumer is under increasing pressure suggests that the largest component of the TSX, namely financials, could be in for a rough ride, too.
With the banks, energy, and consumer discretionary accounting for over 60% of the TSX's value, there is ample reason to take a bearish view of Canada, especially as its vital trade relationship with the US is under threat by the latter's current, shall we say, NAFTA-skeptic administration.
Those who have been paying attention know President Trump has aggressively challenged the viability of NAFTA and other trade deals, and has initiated the most recent US-Canada trade spasm. However, the President is not the only factor contributing to the current state of affairs. To understand why bilateral trade is likely to worsen (to Canada's detriment), a brief history lesson in Canadian nationalism is necessary.
For all their differences, Canada’s elites and plebeians share at least one common trait. For lack of a better term, a national inferiority complex occasionally emerges in the form of anti-US resentments. Canada's elites have learned to pander to these feelings since the nation's birth, at least in words, which has often resulted in the country's self-defeating inability to secure free trade deals with its neighbour to the South.
It is, however, a conscious trade-off. Coddling national resentment has long been employed as a kind of glue to unite a population otherwise prone to splitting into regional factions. More cynical politicians, meanwhile, exploit these resentments to occasionally seek a needed bump in popularity.
US politicians have largely ignored or dismissed these behaviours. This appears to have changed under the new administration. Canadian politicians who play the anti-US card now risk opening the door for their US counterparts to react in kind. In the worst-case scenario, a self-reinforcing loop may emerge, one in which a worsening economy inspires Canada's governing class to fall back on ever more anti-US populism, firing up more nationalism on the US side of the border in the process, further undermining free trade, and causing additional harm to Canada's economy.
Unless you have a scoop on some "can’t miss" Canadian company, I would largely avoid Canada as an investor for the near to medium term.
In The Shadow Of The World's Largest Fish Bowl
There is an unsightly side to the "Canadian national character," assuming such a thing even exists. Unsurprisingly, a sense of inadequacy is rooted in our national personality given that our Southern neighbor is the world's lone superpower, largest economy, and most prolific purveyor of brain-dissolving pop-culture. The more loudly, bombastically, and arrogantly our American friends behave, the more we Canadians reveal, not genuine superiority, but rather thinly veiled envy and resentment.
The Canadian patriot is not unlike the timid, scrawny schoolboy whose big brother is the captain of the football (or hockey) team. Big brother gets all the attention and accolades, is even a bit of a bully at times, not to mention an occasional witless braggart – yet, little brother can only watch, infuriated, as his older sibling always drives away with the pretty girl.
The cultural realm provides the most pungent, and sometimes amusing, examples. Whether it's the Canadian Football League's juvenile “Our balls are bigger” slogans, or the makers of low-grade beer drumming-up sales by flag-waving while deprecating the folks to the South (see here), those nice people to the North are clearly compensating for something. Our behaviour seems even stranger when you consider how overjoyed we become whenever one of our own finds fame and fortune in the US, and we turn mere pop-culture idols into unlikely national heroes.
It all sounds funny, I know, but there’s nothing funny about resentment. It festers, it builds, and it expresses itself in increasingly self-defeating and embarrassing ways. The more one tries to avenge his resentments, the more one exposes his inadequacies to the world.
Once we move beyond the cultural to the political realm, the stakes become higher. Today few would deny the degree to which the Great White North benefited from the Canada-US Free Trade Agreement (FTA) of 1989. An excellent summary of post-FTA economic activity was penned for the 25 year anniversary by Douglas Porter and can be read in its entirety here.
It has been conveniently forgotten that leading up to the 1988 federal election, the Canadian anti-FTA camp appealed to alarmist nationalism, and all but labelled centre-right Conservative Prime Minister, Brian Mulroney, as a traitor selling-out the country to the US. The centre-left Liberal Party aired its now-infamous campaign ad featuring a nefarious be-suited American negotiator erasing the US-Canada border.
The message was clear, free trade meant conquest of Canada by the US. However, a strong economy and the splitting of the anti-FTA vote between the two left-leaning national parties handed the Conservatives and pro-FTA camp an unlikely win in an election many interpreted as a national referendum on free trade with the US.
To be fair to the Liberal Party, whose nationalistic campaign failed to carry the day in 1988, it was actually they who first attempted a free trade deal with the US in 1911. Only in that case, the roles were reversed. During that incarnation, the Liberals were defeated at the polls by Robert Borden’s anti-free trade Conservatives, who appealed to – you guessed it - nationalism.
After years of standing in its own way, Canada finally got its free trade agreement with the US in 1989, and as it happens, would later get one with Mexico, too. The latest dust-up between President Trump and Prime Minister Trudeau appears to place that in jeopardy. Trump has made no secret of his disdain for NAFTA, at times declaring he will "re-negotiate" it, if not "tear it up" completely. Now, whether such comments should be interpreted literally or as a negotiation ploy is unclear, but the recent confrontation suggests something has changed.
Historically, Canadian politicians have known that appearing to "stand up to" the Americans is occasionally expected for the amusement of domestic audiences. In 1997, Liberal Prime Minister Jean Chrétien was overhead (and recorded) telling his Belgian counterpart that he made a point of publicly defying the US because "people like that."
Even Conservative Prime Minister, Stephen Harper, made a point of addressing Canadian sovereignty over the Northwest Passage in his first post-election press conference, declaring, "It is the Canadian people we get our mandate from, not the ambassador of the United States." Such comments are good for Canadian politicians who do not wish to be seen as too cozy with the Americans.
Typically such rhetoric is ignored by US leaders, presumably because they either understand its inherently theatrical nature, or because they genuinely don’t care. The recent spat between Trump and Trudeau seems to be a departure from this precedent. The tone of Mr. Trudeau’s "will not be pushed around" remarks were admittedly more abrasive than normal, but the US response was truly unprecedented in its tone. I’ll spare the gory details, as they are well known by now.
Truth be told, it is typical in international trade that countries employ protectionist activities whenever convenient, like the Canadian dairy tariffs Mr. Trump cited, or US duties on softwood lumber which have long irked Canadians. Mr. Trump’s motivations are well known, as he was elected in part due to the belief by many US workers, justified or otherwise, that they get a raw deal in current trade agreements.
Still we should not forget, dear readers, that former Liberal Prime Minister, Jean Chrétien, swept into power in 1993 at least in part on the promise (which he subsequently broke, see here) that he would "re-negotiate" the NAFTA, or even "tear it up" completely (sound familiar?). We should not assume that only one side of the 49th parallel is prone to occasional bouts of self-defeating nationalism.
Reemerging Cracks In Confederation
For those unfamiliar with Canadian politics, I’ll make this short. This Nordic country’s history has been one of varying degrees of internal in-cohesion and a federal system perennially on the verge of fracturing. Threats of Quebec separation are the most obvious manifestation, but separatist movements occasionally arise in the Western Provinces, too, and there’s even a small Newfoundland independence faction. Meanwhile, constitutional crises seem to represent an endless feature of confederation.
Most recently, the issue of oil and gas pipelines has opened yet another gash in Canadian unity. In October 2017, TransCanada finally threw in the towel on getting regulatory approval for the Energy East Pipeline, which would have carried oil from Alberta and Saskatchewan to St. John, New Brunswick for delivery to domestic and foreign markets. The optics were terrible. Most Canadians saw TransCanada’s struggles as the Federal government’s unwillingness to cross vote-rich Quebec, where opposition to the pipeline was greatest.
This issue highlighted a longstanding problem in Canadian federalism. Unlike most democracies, like the US, Germany, or Switzerland, Canada’s provinces have no equalizing representation in its upper house. Whereas in the US, for example, states are each represented by two senators, somewhat balancing the spectacular numerical advantages that some states, like California or Texas, have in the lower house.
Essentially, this means Canada is truly ruled by its two most populous provinces, Ontario and Quebec. For obvious reasons, this has been a long-standing source of discontent among the remaining provinces, as described by Donald Savioe in the aftermath of Energy East.
That is how Canada has been governed since 1867. Atlantic and Western Canadians look in the mirror and see Quebec and Ontario while Quebec and Ontario only see Quebec and Ontario.
Once the Energy East Pipeline died, criticism of Quebec’s influence inevitably followed. The premiere of New Brunswick lamented the loss of potential jobs in his province thanks to one province’s seeming ability to single-handedly kill a national project. Saskatchewan’s Premiere was even more direct, comparing Western provinces acquiescence to Canada’s federal system to having "Stockholm syndrome." For a country permanently hobbled by internal divisions this was just the latest injury.
Pipelines would emerge again in 2018. The so-called Trans Mountain Pipeline, to carry Alberta oil to the British Columbia coast and on to Asian markets was opposed by BC’s newly elected far-left coalition of the NDP and Green Party. The $7.4 billion lawfully approved pipeline was to be built by the US company, Kinder Morgan (NYSE:KMI), but a surge of opposition from the new BC government and aboriginal groups threatened to stall or outright kill the project.
Ultimately, Kinder Morgan pulled out of the project, forcing the Canadian government to do an embarrassing about face, and step in to build the pipeline itself with taxpayer money. As can be seen here, this issue is one of critical importance to Canada's economy.
Canada's natural resource sector is vitally important to the economy. In 2016, natural resources directly and indirectly accounted for 1.74 million jobs in Canada and 16% of Canadian GDP. No other country in the G7 depends so heavily on natural resources as Canada to support their economic well-being.
At its worst, the rift between Alberta and BC created more than an abstract gash in Canadian unity. In February of this year, Alberta premier Rachel Notley (ironically, from the Alberta variant of the far-left NDP) announced it would stop importing BC wine in retaliation to the latter government’s opposition to the Trans Mountain Pipeline.
Notley conceded the ban on B.C. wine may violate inter-provincial free trade rules, but said Alberta is moving ahead with it anyway.
And thus, the not-so-new trade wars have shown they can affect countries on a domestic level, too.
The ultimate kicker is that the Trans Mountain pipeline will be built anyway with taxpayer money instead of with private capital, while sending a "chilling" message to potential foreign investors, as outlined most recently in the Financial Post.
The biggest takeaway, however, is that even a seemingly localized dispute between two Western NDP-led provinces can exacerbate traditional Canadian constitutional rifts. The leader of Canada’s federal NDP, Tom Mulclair, pointed out (fairly, it would seem) that Prime Minister Trudeau was perfectly willing to let a pipeline die in vote-rich Quebec, while imposing one upon a Western province of lesser electoral significance.
Things Are Only Going To Get Worse
Trade is crucial to Canada’s economy. Exports account for roughly one-third of GDP, with oil and natural gas comprising the largest share of such. With the US accounting for 75% of Canadian exports that essentially translates into a situation in which fully one-quarter of Canada’s GDP is directly tied to US trade. Conversely, exports to Canada account for only about 3% of the US's GDP. In a trade war, Canada will be bringing a proverbial knife to a gunfight.
Unfortunately nationalism is as easy a sell in Canada as it is in the US (or most anywhere else, for that matter). Already, Canadians are threatening to boycott US goods and are doing so very publicly, extending their enthusiasm beyond donut shops to Facebook and Twitter. The problem with all this public grandstanding is that it is visible to the whole world, including the US.
In the information age all is revealed. And since Canadian nationalism has a 150-year history of adopting an anti-American slant, expect the insults and barbs to grow increasingly heated, and expect the media, regardless of national origin, to ecstatically broadcast each new escalation. Don’t even be surprised to once-again see purveyors of cheap beer cash-in on the zeitgeist with new US-bashing commercials, which of course, will be seen beyond the border, too. And you can be sure, Americans will respond in kind.
In a tale dominated by ironies (we Canadians are entitled to abjectly misuse the word "ironic"), Canada's all-important oil and gas industry is the primary casualty of the country’s internal squabbles. In an added twist, it was actually President Obama – so adored by Canadian elites - who shot down the development of yet another pipeline project, Keystone, so desperately needed by the Western Canadian energy sector (see here) to get its products to market. Last year, President Trump actually reversed Obama's decision and approved the Keystone Pipeline. The ultimate irony is that a defeat for the "protectionist" President in 2020 could well reverse that pro-Canada decision on Keystone.
The message is clear. Unless we see oil prices rise spectacularly, times will be increasingly difficult for Canada’s energy industry. I would avoid exposure to this sector completely, except in the unlikely event that some exogenous variable – like a Middle East war – sends energy prices skyward. If one wants exposure to energy, there are plenty of plays in the global economy that do not carry the internal and external risks of the Canadian scene.
Problems for Canada are emerging elsewhere, too. The Bank of Canada recently raised its overnight rate, signaling an uncharacteristic commitment to policy tightening. The problem is that this is happening at a time when Canadians are holding record amounts of consumer debt, a level even higher than their US counterparts held just prior to the 2008 financial crisis.
This will likely exacerbate the current slowing of the domestic retail sector. Meanwhile, the most recent RBC report shows that housing affordability shows little hope of improving in the near term. This, as a whopping 42% of Canadians report that increasing rates will threaten their financial well-being.
For this reason, I would also avoid broader plays on the Canadian economy. Popular ETFs, like the iShares MSCI Canada Index Fund (NY:EWC) have wide exposure to the banking sector, vulnerable in an era of rising rates and overextended consumers, as well as the aforementioned energy sector.
As you can read here, just three sectors - financials, energy, and consumer discretionary - account for over 60% of the TSX's components. If you're a current holder, I would take some profits. The prospect of intensifying trade disputes with the US will only further exacerbate Canada's unattractiveness as an investment destination, for both Canadians and foreigners alike.
One possible piece of good news for the TSX could come from Brazil of all places. The current centre-left candidate for Brazil’s presidency, Ciro Gomes, has recently appealed to the nationalist persuasions of his own countrymen by announcing he would undo Boeing’s (NY:BA) planned joint venture with Brazil’s Embraer (NY:ERJ).
This would theoretically be good news for Canada’s aircraft manufacturer, Bombardier (OTCQX:BDRAF), which recently announced a deal of its own with Europe’s Airbus. However, with Gomes running third in the polls it is perhaps a fleeting hope for Canada's small aviation sector. At any rate, in an age of protectionism, I would avoid the aerospace sector as a general rule, for reasons I first explained here.
The worst-case scenario is an escalation of the rhetoric between the governments of Canada and the US, and as I have shown, there is plenty of historical precedence to suggest this is not only possible, but likely, especially in times of internal political strife. Any pullback from existing free trade agreements will disproportionately affect Canada, and divert national attention away from inter-provincial issues that need resolution.
Worst of all, if the economy slows, Prime Ministers (regardless of political affiliation) will be tempted to ratchet-up anti-US rhetoric to appeal to nationalist sentiments. We can no longer take for granted that the government to the South will ignore such sentiments this time around. The result would be a vicious loop of slowing growth, nationalist fervour, and tightening of trade, leading to a further slowing of growth.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.