Canadian ETFs Are Compelling Under Trump Trade Threats

December 06, 2016

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Deborah Frame, president and chief investment officer of Toronto-based Frame Global. 

Canada is independently stepping up efforts to expand its free-trade agreements worldwide, and in doing so, is better hedged against U.S. protectionism.

After decades of steady progress toward freer trade, the recent rise in protectionist sentiment from the U.S. risks sparking a global trade war. If provoked enough, trading partners including China, Mexico and Canada could retaliate with their own set of beggar-thy-neighbor trade policies.

This would hurt global trade and make worse an already-fragile global economy. But rather than a victim, Canada has been independently negotiating beneficial trade agreements with the rest of the world, and keeping in its back pocket the significant leverage it has over the U.S. when it comes to oil exports.

Canada Wants Free Trade, Not Disputes

Protectionist policies during the Great Depression were called "beggar thy neighbor" as they sought to shift shrinking demand away from imports in favor of domestic goods. In trade disputes between nations, the larger country usually fares better in imposing its will in a political setting where power triumphs.

It is no wonder that President-elect Donald Trump, with his focus on America first, sees trade disputes as preferred over trade agreements. But trade disputes led by the bigger guy never works out for the bigger guy. Policies like the Smoot-Hawley Tariff Act of 1930 led to a retaliatory cycle that helped to aggravate the Depression.

The benefit does not come from a mercantilist maximizing of the surplus of exports over imports. Treating exports as “good” and imports as “bad” for an economy ignores how imports contribute to rising living standards as much or even more than exports.

The costs of these policies are even greater now than they were in 1930: The world economy is more deeply integrated through trade and investment linkages, and imports are much more likely to be inputs in the production processes of domestic industries as part of global value chains.

Trade Barriers Impact Domestic Production

Trade barriers will primarily disrupt the internal value chains of U.S. firms, raising their costs of production while they face shrinking markets, thereby disproportionately hurting U.S. companies.

Studies support that countries that chose economic independence—such as post-war Latin America, China before 1978, India before 1991, or Cuba and North Korea—remained near the bottom of global rankings of economic development.

 

Countries that promote exports but discourage imports, such as Japan and several other Asian nations, have low levels of productivity in their domestic economy and high consumer prices.

Trade agreements replace the state-to-state resolution of trade disputes with investor-to-state resolution. Disputes are resolved with investor-to-state settlements in an arbitral setting within the rules set by governments, such as the dispute between Canada and the U.S. over softwood lumber. Trade agreements allow companies to plan long-term decisions on where to locate production and distribution with more certainty about the “rules of the game.”

US & Canada Under NAFTA

Perhaps the most compelling explanation as to how the United States functions as an economic partner rather than competitor due to the unique nature of bilateral trade under NAFTA is to look at its trade with Canada.

The U.S. continues to dominate Canada’s international trade flows, accounting for three-quarters of total exports and two-thirds of imports. Canada’s reliance on the U.S. for trade has fallen over the past two decades, especially with the emergence of Asian nations such as China and South Korea, both as suppliers of manufactured goods and as export markets for natural resources.

The value of U.S. content in imports from Canada averages 25%. Two-way trade between the U.S. and Canada amounted to about $760 billion in 2015, but the U.S. had a goods and services trade surplus of $11.9 billion in 2015. With autos and the communication technology sector, 50% of all inputs originate in the U.S., while in construction and natural resources, imports amount to less than 20% of all inputs.

Cars built in North America cross the U.S. borders eight times during production, integrating materials and parts developed in Mexico and Canada. The Detroit metropolitan area, a hub of the motor vehicle industry, exports more goods to Mexico than any other city in the U.S.

The demise of the recently approved Trans-Pacific Partnership before it was off the ground is not good news for the global economy, but is actually good news for Canada. Canada is planning to build pipelines to its Western and Eastern coasts for oil and gas shipments to Asia and Europe. It recently signed an agreement with the European Union and continues to negotiate with Asia-Pacific countries.

 

US Energy Security

Most important to the U.S. is energy security. Under NAFTA, Canada guarantees oil and gas shipments to the U.S. at average peak-export levels; scrapping NAFTA would release Canada from that commitment.

Canadian crude oil exports to the United States reached their highest level ever of 3.4 million barrels per day in early 2016, according to preliminary data from the U.S. Energy Information Administration. Canadian oil now accounts for 45% of all U.S. crude imports.

Also, Canada and the U.S. share the Great Lakes, jointly providing access to ocean-going vessels, and are closely linked through oil and gas pipelines, railways, highways, electricity grids and telecommunications networks. Cooperative agreements would be up for review in a new protectionist world.

Canada is no longer hostage to its southern neighbor when it comes to trade, which is why we find Canadian ETFs such as the ones below so compelling:

iShares MSCI Canada ETF (EWC) seeks to track the investment results of an index composed of Canadian equities. It provides exposure to large and midsize companies in Canada.

The iShares Currency Hedged MSCI Canada ETF (HEWC) seeks to track the investment results of an index composed of large- and midcapitalization Canadian equities while mitigating exposure to fluctuations between the value of the Canadian dollar and the U.S. dollar.

What’s interesting is that both the unhedged and hedged ETFs are similarly outperforming U.S. stocks in 2016.

Chart courtesy of StockCharts.com

 

Deborah Frame is president and chief investment officer of Frame Global. She also co-heads the Canadian Chapter of Women in ETFs. Frame Global Asset Management currently does not hold positions in EWC or HEWC. The company is a Toronto-based asset management firm that uses ETFs exclusively in its top-down global asset allocating strategies. The firm provides innovative, subadvised investment models to clients in the U.S. and Canada using tactical asset allocation models that are focused on client risk tolerance thresholds as defined by downside risk, rather than the traditional measure of risk as volatility or uncertainty. www.frameglobal.com

 

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