A new NAFTA: To be or not to be?

Posted: Friday, February 23, 2018 - 08:21 EST

Summary

  • As 2017 progressed, it became clear that the U.S. may decide to walk away from the North American Free Trade Agreement.
  • By all accounts, negotiations between the three countries aimed at updating the treaty are more or less at an impasse.
  • Should this deadlock not be broken, it’s very possible that the Trump administration will issue a Notice of Intent to terminate the accord. Such a move would likely set in motion a battle between Congress and the administration over the legality of a unilateral withdrawal.
  • While a renegotiated NAFTA is still the most likely scenario, the whole process will probably drag on for much longer than markets currently anticipate. Perhaps more importantly, investors do not seem to be adequately pricing in the possibility that NAFTA may be terminated.
  • A close look at the Canadian auto sector and specifically Magna, reveals how crucial NAFTA is for Canada’s economy.
  • Since he took office, there has been considerable speculation over whether President Trump truly intends to walk away from the North American Free Trade Agreement. Some observers have insisted that Trump is serious, while others have maintained that his threats at pulling the U.S. out of the accord are merely a bargaining ploy.

By now, the former position seems more credible. In addition to the constant musings about leaving NAFTA, the U.S. administration’s conduct during the negotiations gives little hope that they’re serious about finding a compromise on key issues. Indeed, both Canada and Mexico have complained that the U.S. has submitted untenable demands for an updated agreement, while at the same time offering practically nothing to the other two countries.

What Happens if the U.S. Walks Away?

Pulling out of NAFTA is easier said than done, because it’s not at all clear that it can be done without congressional approval. In fact, only once in its history (1866) has the United States unilaterally abrogated a trade agreement without the consent of the legislative branch. In the event that the Trump administration does deliver a Notice of Intent to terminate U.S. participation, that would likely set in motion a battle between Congress and the White House over the legality of such a move. Should the proposed withdrawal go to Congress for approval, it’s not clear which way they would vote.

It’s important to note that during any litigation/vote process, NAFTA would continue as is. Furthermore, it’s possible that even if NAFTA is terminated, the old Free Trade Agreement (“FTA”) would come back into force, as the governing trade treaty for the continent. For its part, the FTA was actually never dissolved, but rather superseded by NAFTA. That said, Congress may have to re-approve the FTA. Finally, if neither NAFTA or the FTA are operative due to U.S. abrogation, that would leave WTO rules to set the terms of trade. Canada, with its Most Favoured Nation designation, would see duties averaging approximately 4%, as long as the U.S. does not decide to abandon the WTO as well.

What the U.S. Wants

The Trump administration’s position is that NAFTA is fundamentally a bad deal for the United States. Its goal is a reduced trade deficit with Canada and Mexico, and believes the two countries must make concessions in return for nothing to make this happen. There are a number of specific ways the U.S. has proposed achieving its objective of more balanced trade, all of which have been met with fierce resistance:

  • Changes to auto rules of origin: the U.S. wants an increase in the regional content requirement from 62.5% to 80%. It also seeks minimum U.S. content of 50% in auto production. (Canada and Mexico argue that this would violate the World Trade Organization (“WTO”) rules.)
  • 1:1 procurement access. In essence, this demand insists that for every dollar of government procurement contracts Canadian or Mexican companies win in the U.S., U.S. companies win an equal amount in those countries. (This demand is contrary to both the current NAFTA and WTO rules. In addition, given how much bigger the U.S. economy is than Mexico or Canada, it’s understandably very unpalatable for the two smaller countries.)
  • The elimination of the Chapter 19 dispute settlement mechanism. (Both Mexico and Canada see this as a total non-starter.)
  • A so-called ‘sunset clause’ which would require NAFTA to be renewed every 5 years by all three countries. (This idea has been met with fierce resistance as businesses want long-term predictability before making key investments.)
  • Expanded market access, particularly in sectors such as dairy, agriculture, wine and telecommunications. (For its part, Canada is under a lot of pressure from farmers to protect supply management in dairy).

Implications for Canada

There are a number of key implications for Canada, as a result of the NAFTA uncertainty. First, it is already pursuing accelerated bilateral trade deals with the U.K. and China, and will also do so with Mexico if NAFTA is abandoned. Second, it’s not out of the question that the Bank of Canada surprises markets with a rate cut in 2018 to cushion the blow of any trade shock. Economists have estimated that in a no-NAFTA world, Canadian GDP could be reduced by 1% per annum over 5-10 years, although some of the impact would be offset by a lower Canadian dollar. It’s difficult to overstate how important the U.S. market is for Canadian trade. As the following chart shows, eight sectors in Canada, which ship over 50% of their exports to the U.S. market, account for just under $300 billion in exports. As a result, a termination of NAFTA would have far reaching implications for the Canadian economy.

Sector % of Shipments $Billions
Computers/electronics 84 13.8
Machinery 71 31.2
Transport Equipment 69 130.6
Electrical Products 60 9.9
Chemicals 59 50.3
Textiles 59 5.9
Primary Metals 51 45.3
Furniture 50 11.5

This pain would not be felt uniformly throughout the country: Ontario is the most ‘disrupted’ province, while B.C. and the Maritimes are the least so. Of note, the least exposed Canadian province is still more exposed economically to a NAFTA termination than the most exposed U.S. state. In short, Canada has much more to lose than the U.S. does, relatively speaking.

Magna: A Case Study

To see how important NAFTA is for Canada, it’s instructive to look at the auto sector and particularly auto parts giant Magna. Canada is currently the ninth-largest auto producer in the world, and fourth largest auto exporter by value, producing 2.4 million vehicles annually. Vehicles account for $64 billion in exports, which is 16.5% of total exports, making it a very significant contributor to GDP.

Magna is the largest auto parts maker in Canada (3rd in the world) with over 155,000 employees globally (approximately 19,000 in Canada and 27,000 in Mexico) and over $36 billion in sales. The company’s sales for 2016 are roughly broken down as:

U.S. Canada Mexico Europe Asia
28% 18% 14% 35% 7%

Magna’s CEO, Don Walker, said in a recent BNN interview that they currently have no contingency plan with regards to NAFTA uncertainty. As it stands, auto parts are a highly integrated industry and any changes would be disruptive, as companies become less competitive without access to cheaper labour in Mexico. Chinese imports, to use one example, could pose a threat to the Canadian auto parts sector should NAFTA be meaningfully altered or ripped up altogether.

Of course, there are numerous factors affecting a company like Magna that should be taken into consideration by investors. We would break down the pros and cons of the stock as follows:

Strengths Threats
  • Globally situated
  • Strong BalanceSheet
  • Attractively Valued
  • Exposure to recovering Europe and growing China markets
  • Electric vehicles/Autonomous Driving
  • NAFTA renegotiation
  • Electric vehicles/Autonomous Driving
  • Peak Auto - especially North America

Implications for Markets

While the most likely outcome remains an updated NAFTA, the process will be, at best, laborious. It will take years, not months, to achieve a successful conclusion to negotiations. For investors and businesses, opening up NAFTA means prolonged uncertainty. This uncertainty may manifest itself in heightened volatility, as currency markets seek to find new equilibrium real exchanges rates, bond ma