devil’s advocate – noun Someone who supports an opposite argument or one that is not popular in order to make people think.
– Cambridge Dictionary
On March 3, U.S. President Donald Trump followed through with the implementation of a slate of tariffs on Canadian and Mexican goods, marking the start of a North American trade war. Canada fired back with retaliatory tariffs.
Mexico is holding fire for now, hoping there is still room for negotiation. On March 4, hints emerged from the U.S. administration that a comprise might be possible.
Tariffs are a negative for the entire North American economy; they risk increasing inflation and lowering economic growth. In limited, targeted circumstances tariffs can be useful instruments. However, if they were a viable and useful broad-based economic tool, wouldn’t modern democratic capitalist economies already be using them extensively? A few hundred years of economic experience shows the road to prosperity isn’t paved with tariffs.
Late February saw the beginnings of a tariff tantrum in capital markets, with equity market weakness in North America and falling bond yields. The equity market weakness is understandable. The bond market reaction is more nuanced. There was uncertainty around which of the consequences from tariffs bond investors would weigh more heavily – inflation or weaker growth? If inflation was the greater concern, that should bring higher yields; if a hit to growth was the greater concern, that should usher in lower bond yields. February’s lower bond yields point to weaker growth as the bigger concern.
It is important to put the market moves into context. The S&P/TSX Composite and S&P 500 were making fresh highs earlier in 2025 as the macroeconomic and corporate earnings growth backdrop was pretty good. From those peaks to
the market close on March 4, Canadian stocks had melted about 5%. The S&P 500 was down 6% on the back of some
U.S. economic data that showed the economy might be slowing a bit as well as the initial heightened tariff rhetoric. It is good to see capital markets taking note and correctly pricing these as negatives. This capital market reaction is an important feedback loop for the U.S. administration. Decision makers will use it to calibrate the magnitude and speed of implementing their agenda.
Aside from the late-month tariff tantrum, February brought an unwind of the overall Trump-trade and a reversal of familiar market movements where complacency had set in. A healthy rotation to some long-unloved trades arose in their wake. The trades that reversed to the negative include a strong U.S. dollar, U.S. equity market exceptionalism, and the belief that tariffs and excessive U.S. government spending would keep U.S. inflation and bond yields elevated. The unloved trades that experienced a renaissance included the general consensus that European equities are troubled, and China and Chinese stocks uninvestable.
In fact, February saw Chinese stocks rocket higher by 11.5%. European equities were up 3.3%, bringing the EuroStoxx 50 Index to an 11.6% rise for the year as of February 28. Canadian equities were flat in February. Despite the trade war fallout, market declines on the year remain modest. As of the market close March 4, year to date, the S&P/TSX is down 0.6% and the S&P 500 is down 1.8%. In the U.S., the big-is-beautiful Magnificent 7 trade that had so much momentum is taking a breather. The tech-heavy NASDAQ fell 4% in February.
However, there is good news on U.S. corporate earnings as they surprised to the upside; Q4 S&P 500 earnings growth is handily beating expectations and earnings growth is the highest since the post-COVID rebound. Our view that, globally, earnings have room to surprise to the upside is playing out.
On the economic front, it was expected that the U.S. economy would be (forever?) firm and the rest of the world (including Canada) would remain in a funk. Instead, February saw cracks appear in the U.S. economic picture. Many of the data points are still solid, just softening. Our base case does call for the U.S. economy to slow. A cooling of U.S. growth and a return to more constructive inflation readings opens the door for the U.S. Federal Reserve to continue lowering interest rates (the Fed’s preferred measure, U.S. core PCE inflation, fell from an annual rate of 2.9% in December to 2.7% in January). This should weaken the U.S. dollar, which in turn helps to narrow the U.S. trade deficit. It also helps support economic growth. Growth scares have happened before. We aren’t dismissing the softening data, but there are many caveats. We are keeping a watchful eye.
What about ex-U.S. economic growth?
After final revisions, the eurozone saw growth to close out 2024. Real GDP rose 0.1% over Q4 2024 (0.2% annualized). This isn’t gangbuster growth, but in capital markets everything is measured versus expectations. Little was expected from the eurozone, so small victories against downbeat sentiment and cheaper equity valuations are the recipe for a pop.
The outperformance of Chinese stocks in February occurred alongside a changing backdrop. Chinese stocks were the cheapest play on earth. Investors (including us) were rethinking their weightings toward China for a number of reasons. U.S. trade antagonism toward China is currently less harsh than expected and China is continuing its economic stimulus measures. An interesting development in AI called DeepSeek erupted, reminding investors that not too long ago China’s tech companies were market darlings. Chinese equity markets were very washed out (many markets have been down more than 50% in the past few years). Sharp reversals like February’s are typical when they come.
Canada tops the list of surprises
The Canadian economy enters this tariff shock on a stronger footing than forecast. Canada arguably has the most interest-rate-sensitive economy in the world. Quietly, hidden behind all the attention on domestic politics and tariffs, our economy is responding to declining interest rates and a robust U.S. economy. Canadian economic growth clocked in at a stronger-than-expected annualized 2.6% in Q4 2024. That’s the best non-pandemic domestic demand performance since 2017. Led by auto sales, we saw momentum in rate- sensitive, big-ticket spending. Nationally, real estate markets are stable. Unemployment is elevated, but job creation accelerated through the turn of the year. For context, the current unemployment rate of 6.6% is below the 7.0% median since 2000. The participation rate for those aged 15 to 64 is 80%, the highest on record aside from the post- pandemic blip. While it is warming up a smidge, Canada’s inflation rate remains among the lowest in the developed world. Given wage growth north of 4%, real wages are rising at the strongest pace since at least the early 1990s. Additionally, our exports are getting a competitive boost from a weak loonie, commodity prices are favourable, and government finances are in a manageable position (enviable compared to the U.S.).
Canadian corporate earnings are a part of the positive global surprise story too. With over 75% of companies reporting their latest earnings, S&P/TSX earnings growth is 8.4%, beating expectations by more than 5%. Ten out of 11 sectors delivered growth and upside earnings surprises.
Our strategy – Balanced, with an equity bias
We continue to follow our disciplined and patient approach. We are overweight U.S. and Canadian equities. We remain neutral in our international developed markets (Europe and Japan) and emerging markets equity allocations.
We used equity market strength last November and again in mid-February to trim our U.S. and Canadian equities. The proceeds were deployed toward the safety of cash and high-quality bonds. This is not a major change of view – it’s a recognition of the uncertain landscape. During the early February fire drill on tariffs, cash and high-quality bonds delivered the protection and upside expected from these safe assets. We moved to ensure we have a little more of them for now. The safety of bonds continues through this period of volatility with the FTSE Universe Bond Index up 2.6% year to date as of March 4.
Our U.S. asset exposure is predominantly U.S. equities, with some in fixed income and alternative assets. Most are unhedged from a currency standpoint. While these investments are compelling on their own merits, the U.S. dollar exposure provides a lift to portfolios for Canadian investors at a time when the loonie is under pressure.
The S&P/TSX is not the Canadian economy: 60% of the index is in financials, energy and materials. Tariffs on oil and critical minerals are 10%; here the currency helps, plus U.S. buyers have few substitute options. The financial sector’s U.S. earnings largely stem from operations domiciled in the U.S. – where there are no tariffs. Similarly, there are no tariffs on U.S. situs operations and many of Canada’s largest companies have extensive U.S. domiciled operations. Our weak loonie is difficult for some but boosts exporters and inflates U.S. dollar profits, including repatriated profits from these Canadian companies’ U.S. operations.
The last word – Devil’s advocate
We don’t want to minimize the impact of tariffs on the Canadian economy or even Canadian stocks. Indeed, the ongoing uncertainty of tariffs has been dampening business investment in Canada. However, we sense clients are jumping to conclusions and expressing a level of fear that we’d like to address.
To begin, let’s talk about the tariffs themselves. Remember, we are talking tariffs, not sanctions or embargoes; cross- border business activity will not fall to zero. It’s also noteworthy that the tariffs are focused on goods while the North American economy is heavily tilted toward a service- based economy, including trade in this category.
Although tariffs are a negative, several factors should be considered. First, tariff policies may be initially – or eventually, given negative ramifications – more item/sector targeted than this opening salvo. Second, the exchange rate is an important shock absorber for the economic impact of tariffs; the loonie is down 8% from September 2024. Third, American consumers will likely eat some of the tariffs when they buy from Canadian businesses that have competitive advantages and/or significant market share. Businesses subject to a greater degree of U.S. domestic competition will bear more of the brunt of tariffs.
If the tariffs last, we can expect a Canadian fiscal and monetary policy response. That will help Canadian businesses and households weather the storm.
And it may be just a storm. We don’t know if the tariffs will stick – a backlash from U.S. capital markets, business leaders and voters could spur a rethink. These are the best chances to see these ill-advised policies reduced or reversed. There are also legal considerations, and legal challenges are expected. President Trump is hiding behind national security powers to enact the tariffs yet openly talks about them as revenue generators and industrial policy tools. We aren’t naïve in this respect, but it is an avenue.
We do think mounting negative blowback will eventually generate so much pressure that the President will see the merit of taking one of the available off-ramps while still claiming a victory. We know from experience that there can be lots of room for negotiation. Even President Trump and the Republicans have acknowledged that the NAFTA/USMCA trade agreements have led to better economic outcomes for all three countries. Which country benefitted more is up for debate – not the concept of trade itself.
Available off-ramps include recognizing actions already taken by Canada and Mexico on border security and immigration. It’s also reasonable to think that Canada and Mexico would agree to reopen the USMCA negotiations early. Imposing tariffs on China is another potential olive branch. At the moment, Mr. Trump doesn’t seem interested in these avenues, so wisdom suggests holding onto these cards until a more opportune time.
Lastly, we are advocates (not the devil’s) of the idea that this tariff threat has some silver linings. The national outpouring of Canadian patriotism is heart-warming, something we always knew was inside us but not so near the surface. These emotions are a wake-up call to examine how we do business in this country. It is motivating conversations around pipelines and resource policy, trade relationships, interprovincial trade, taxation, and fiscal policy, pointing them in constructive directions. This external threat is changing the narrative on measures designed to drive economic growth, investment and productivity. We have an opportunity to strengthen Canada as a place to invest, work and live.
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
