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How Will NAFTA Impact the US, Mexico, Canada and China?

The US and Mexico agreed new terms in principle for NAFTA, but Canada is yet to re-join the deal. Experts tell us whether a deal will be signed and how it will affect each nation

David Brenchley 6 September, 2018 | 7:31AM

Donald Trump President of the United State negotiates NAFTA deal with Mexico and Canada trade tariffs

The North American Free Trade Agreement (NAFTA) took a back seat for the first half of 2018 as testy relations between the US and China dominated trade talks. However, the issue is now firmly front and centre for politicians, and stock markets.

While on the Presidential election trail two years ago, Donald Trump called NAFTA “the single worst trade deal ever approved” in US history. In August 2017, he repeated that claim on Twitter as he began re-negotiation talks with Mexico and Canada.

A year later – following many threats to pull out of the deal entirely – and there has been progress. Last week, it was confirmed that the US and Mexico had agreed, “in principle”, to new terms.

Now, the onus is very much on the US to bring on board Canada, but that may well prove tricky. The two parties have had preliminary talks and, after a break over the long Labor Day weekend, negotiations resumed in earnest on Wednesday.

It appears Mexico has ceded to some of Trump’s demands; Canada aren’t guaranteed to do similar. Trump continues his abrasive approach on the issue, tweeting “there is no political necessity to keep Canada in the new NAFTA deal”.

However, this does not seem to faze his North American neighbours, with Prime Minister Justin Trudeau seemingly taking a page out of Theresa May’s Brexit playbook, countering: “No NAFTA is better than a bad BAFTA deal for Canadians, and that’s what we are going to stay with."

The New NAFTA

The main changes are around automobiles. In the current agreement, companies must manufacture at least 62.5% of a passenger car or light truck’s value in North America. That threshold will rise to 75%.

Further, a new rule stipulates that at least 40-45% of a car must be made by workers earning at least $16 an hour. That’s more than five times the amount Mexican auto sector workers currently earn.

On this point, economists at Bank of America Merrill Lynch note comments by Mexican authorities that state 70% of vehicles produced in the region already satisfy the new requirements. For the other 30%, a two-year period will be given to comply and an interim Most Favourable Nation tariff of just 2.5% will be applied.

Other areas the agreement updated were regarding agriculture and intellectual property. Alejo Czerwonko, director of emerging markets investment strategy at UBS Wealth Management, sees the development as “a step in the right direction” towards modernising an agreement that is 24 years old.

The US has already allayed Canadian fears around the sunset termination clause. Trump’s administration had initially wanted the agreement negotiated every five years, but has agreed a 16-year clause, which BAML’s economists reckon Canada will find acceptable.

The US also wants to eliminate Chapter 19 of the agreement, an important resolution mechanism. This is the current main sticking point for Canada, but BAML also thinks this will be resolved acceptably for all parties.

“Mexico managed to preserve Chapter 20 and Chapter 11 and part of Chapter 19,” the economists note. “If the US shows flexibility in Chapter 19, Canada would have no big reason to remain outside the agreement.”

Timeframes are tight for bringing Canada back into the fold. The US and Mexico both want President Trump and Enrique Peña Nieto to sign the deal by 1 December, which is when Andrés Manuel López Obrador, known as AMLO, takes over as President of Mexico.

This will ensure AMLO can focus on putting through the populist policies upon which he campaigned.

Czerwonko expects the countries to eventually reach a trilateral deal. Still, any three-way agreement, or bilateral deal between the US and Mexico, will need to be agreed by Congress before it can come into force. Clearly, Canada being part of the deal will help on that front.

How Will a New NAFTA Impact All Parties?

For the US, this year has largely been about its trade skirmish with China. However, NAFTA is of great importance to the States, Edward Park, says investment director at Brooks Macdonald, as Canada and Mexico are its largest single country export markets.

It’s also more balanced than other relationships the US has, he adds. Canada, for example, represents $282.3 billion of exports and $299.3 billion of imports for the US. US exports to China, on the other hand, are just $129.9 billion; its imports from China, meanwhile, total $505.5 billion.

“This means if a trade deal does not materialise with Canada, there could be a more significant impact on US exporters and supply chains than negotiations with other trade partners,” Park continues.

There is, of course, still a worry that the US will dump NAFTA altogether as a worst-case scenario. This would not be good for Mexico’s economy in the long run, says Verena Wachnitz, portfolio manager of the T. Rowe Price Latin American Equity fund.

While that is true, counters Park, the impact of no deal would be largely sector specific, as in many areas NAFTA trading terms are relatively close to WTO rules. Some areas would bear the brunt of no deal much more than others. Mexican light-trucks, for instance, can currently enter the US tariff-free; under WTO rules this would rise to 25%.

But should a deal eventually be signed, first and foremost it will reduce uncertainty and remove a key tail risk for the Mexican economy, says Douglas Reed, global strategist and economist at Newton Investment Management.

A good deal would benefit Canada, too, with the obvious positive being a reduction of uncertainty in US-Canada trade relations. Current uncertainty will likely keep Canadian asset prices volatile for the time being, says BAML.

Will a NAFTA Deal Impact US-China Trade Relations?

The next question is whether any deal between the North American countries will have a spill-over into trade talks between the US and China, which don’t look like improving any time soon. One suggestion is it proves Trump is willing to be flexible around trade.

BAML thinks the US-Mexico deal reduces the risk of escalation of global trade wars, “as it provides a path for an eventual US-China agreement, even if in principle”.

But Czerwonko is more cautious, warning clients against extrapolating NAFTA optimism to the realm of US-China bilateral relationships. “Trump administration documents demonstrate that current concerns about China reach beyond the narrow issue of trade, suggesting they are not going to dissipate easily.”

Lafferty sees little movement on the China front until President Xi Jinping visits the US in late autumn. The likelihood is trump will place tariffs on a further $200 billion of Chinese goods, possibly as soon as this week, with $60 billion in retaliation from China.

Park also points out “the US has far less to lose by embarking on a protectionist trade war, as the amount of imports China can levy tariffs on is more limited”. “Should Donald Trump start to gain traction in signing US friendly trade deals it is likely to solidify the harder line that the administration is adopting with China.”

Investor Positioning

Wachnitz says Mexican assets performed modestly, but positively, last week – the peso strengthened by less than 1% after the announcement and maintains an “AMLO risk premium”, which she doesn’t expect to disappear anytime soon. This suggests the market was already discounting a high probability of a trade agreement.

On a more global view, Janet Johnston, portfolio manager at active ETF provider TrimTabs Asset Management, says her firm’s TrimTabs All Cap US Free Cash Flow ETF (TTAC) recently “took out a couple of semiconductor names where the supply chain is really complicated”, to reduce exposure to the US-China trade war.

Czerwonko says UBS recently reduced its overweight position in global equities, bringing its overall tactical asset allocation stance to broadly neutral. “A key reason for our risk reduction was our view that the market was not pricing in the increased risk of the US-China tariff issue.”

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
T. Rowe Price Latin American Eq A USD12.63 USD0.14
TrimTabs All Cap US Free-Cash-Flow ETF  

About Author

David Brenchley

David Brenchley  is a Reporter for Morningstar.co.uk

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