As the dust settles following the U.S. election, we are slowly getting a clearer idea of the policy decisions and actions that will come as Donald Trump assumes the presidency. Despite the positive reaction so far from equity markets, uncertainty remains over which policies touted during the campaign will be fully pursued. His promise to scrap the Trans Pacific Partnership (TPP) is set to be followed through, and a further review of North American trade relations appears likely. Other questions about energy, infrastructure and taxes still loom strongly. What knock-on effects of the new administration can be expected for the Canadian economy? While we wait for further policy clarity, we anticipate that five key issues will be critical to watch and prepare for: 1. Trade protectionism - Which sectors are most at risk? 2. Energy policy - What opportunities and threats for oil and gas? 3. Higher U.S. interest rates - How will real estate and banking be impacted? 4. Lower taxes - Will this promote a “brain drain”? 5. Infrastructure boom - Will this present opportunities for Canadian companies? $690B the value of goods and services traded between Canada and the U.S. in 2015. ~11.5M jobs dependent upon trade and investment between both Canada and the U.S. 35/50 Canada is the top export destination for 35 of the 50 U.S. states. At stake on both sides of the 49th parallel Source: Global Affairs Canada 1. Globe & Mail November 22, 2016 Trade protectionism During his election campaign Trump clearly stated that he will put America first and bring back jobs to the U.S. His speeches have frequently focused on reinvigorating U.S. manufacturing – automotive and steel in particular - without any real detail on how these jobs will actually materialize. Nonetheless, protectionism runs the risk of becoming a negative for international trade because the current flow of consumer goods imported from low cost countries could be curtailed. On November 21, Trump stated that he will withdraw from the Trans-Pacific-Partnership Agreement (TPP), a trade deal among 12 Pacific Rim countries. On November 22, Canada’s International Trade Minister, Chrystia Freeland, said the TPP can’t come into force without the United States. Trump repeatedly attacked NAFTA during his campaign, saying he would “tear it apart”. Indeed, as President, he can terminate NAFTA without approval from Congress. Notwithstanding this, we are of the view that the likelihood of ending NAFTA is relatively low because of the extremely large transitional costs. However, there is a high potential for disruption if the U.S. seeks instead to renegotiate certain of its terms. We do expect that the new administration will introduce tariffs for other countries, such as China and likely Mexico for any trade that falls outside the NAFTA agreement. What does trade protectionism mean for Canada? The nature of the trade relationship between the U.S. and Canada suggests to us that there is low likelihood for significant tariffs on the large majority of Canadian products sold in the U.S. Indeed, our trade relationship with the U.S. is inherently complex with some products, particularly in the automotive sector, crossing the border several times before a vehicle is ready for sale. • Industries such as automotive, aerospace and food products are highly integrated between Canada and the U.S. Nearly two-thirds of products and services that cross the Canada/U.S. border are inputs for final products and roughly 13 percent of imports from Canada go into U.S. products sold to third countries1 . • The new U.S. administration will need to analyze how the current levels of trade benefit the U.S. and the impact to the cost of living of everyday Americans any changes could bring. • Softwood lumber and livestock exports are two potential targets for protectionist policy. Canadian softwood lumber is excluded from NAFTA and has historically been subject to high tariffs. Bilateral lumber tariffs have been in re-negotiation for over a year now and there is potential for the new administration to take an even tougher stance on Canadian imports as part of an on-going trade war. 1 Canada buys more from the U.S. than does any other nation – including all 28 EU countries. Source: www.can-am.gc.ca, Canada-U.S. Relations 3 • In terms of non-tariff barriers (e.g. the ‘Buy American’ act), the administration can potentially act without approval from Congress only in cases where trading partners are identified as using ‘unfair’ trade practices or currency manipulation. We do not expect that to apply to Canada other than in areas that have been subject to trade wars for many years, such as lumber and beef as outlined above. • It is possible the new administration will look to expand non-tariff barriers by getting support from Congress to protect certain industries or to ensure that the benefits of a major infrastructure program stay in the U.S. This may act to reduce the benefits that certain Canadian companies would reap from such a program. • With approximately nine million U.S. jobs dependent upon trade and investment with Canada and the significant transitional costs involved with dismantling NAFTA and negotiating new trade agreements, we are of the opinion that the new administration will resort to actions that do not violate NAFTA, yet give the appearance of being ‘tough on trade’. • It may be prudent for Canada to consider working closely with the U.S. to solve the issues of NAFTA and design what a new deal with Mexico could look like, rather than taking an adversarial approach with the new administration in order to effectively manage the evolution of trade arrangements across North America. • We consider the overall impact of the TPP on Canada would have been a modest economic gain with some potential losers (e.g. auto and dairy sectors) and winners (e.g. agriculture and food processing). There was talk at the recent APEC summit in Peru of the remaining 11 member countries continuing with it, and possibly inviting others to join, but that hope seems slim at best and would take years of renegotiation before it could be ratified and signed by all participating countries. NAFTA and immigration During the campaign, Trump was very vocal about illegal immigration, yet he spoke sparingly in relation to his corporate immigration platform. It is possible that any renegotiation of the NAFTA terms could impact certain classifications of professionals who are currently eligible to transfer between the U.S., Canada and Mexico for employment purposes. What does this mean for Canada? • From a corporate immigration perspective, the changes proposed by Trump could impact companies both in the U.S. and Canada, particularly those engaging in cross-border business. Depending on what changes may eventually be negotiated within NAFTA, cross-border travel and corporate global mobility programs could be impacted. 4 Energy policy Trump’s energy policy proposes to lift restrictions on all sources of American energy. This will lead to more projects available to exploration, production and distribution companies. The expansion in the U.S. energy sector should reduce their need for energy imports. • There is an expectation that Trump’s presidency will result in increased U.S. coal production - shares of the largest coal companies in the U.S. went up by over 20 percent upon the announcement of election results. However, U.S. coal production has declined by about 25 percent since 2008, while the cost of solar and wind power has been dropping and will likely continue to do so. Perhaps most importantly, natural gas remains cheap and plentiful. Coal-fired plants take up to four years to build and have an expected life of around 40 years making construction of new plants contingent on a long-term view about future energy policy. There is no guarantee that any subsequent U.S. government will be as friendly towards coal. The power of states may further limit the potential for a revival of coal-fired plants. Both cost and risk factors favour the construction of gas-fired power plants over coalfired ones, which in turn is expected to keep the coal industry from expanding. That being said, given the abundant supply of both coal and natural gas in the U.S., we expect that natural gas prices will remain depressed over a longer period than anticipated before the U.S. election. • Trump has said he favours the construction of the Keystone XL pipeline. He also has a plan to create a North American market for oil, leveraging U.S. shale oil producers amongst others, to prevent oil from OPEC countries entering the market. What does the energy policy mean for Canada? All energy sectors would be impacted by the new U.S. administration’s intent to change and relax environmental policy with its energy-friendly position. Canada’s commitments to carbon reduction and the Paris Agreement to limit and mitigate greenhouse gas emissions could put Canadian energy producers at a competitive disadvantage with their U.S. counterparts. Natural Gas • Most Canadian natural gas resources require prices that are higher than the current ones to justify investment. With prospects for continuing depressed natural gas prices, Canadian natural gas industry should not rely on higher prices in the foreseeable future but instead should strive to become more competitive and look for alternative markets. • Governments will need to manage their pursuit of clean innovation, an important priority in this country for both managing competitiveness and our environmental impact, bearing in mind that a similar agenda may not impact natural gas producers in the U.S. • Governments may also consider encouraging the development of pipelines and manufacturing processes that use natural gas as a major input, to help overcome the large transportation costs faced by Canadian producers, which combined with low natural gas prices creates less incentive for investment in the sector. 2 5 Oil • The Keystone XL pipeline, while allowing Canadian oil supply to the U.S., would still face strong competition from rising shale oil producers in the U.S. and only be able to compete if they are costeffective. • Trump has stated that he intends to create a separate North American oil market. If the new administration does carry out its plan to stop bringing in low cost imports from outside North America, domestic producers could see price increases due to this reduced supply, which would be beneficial for Canada. Furthermore, restricted or reduced supply under this policy could potentially provide Canada with a larger share of the North American market if the U.S. is unable to meet its own demand. • Higher oil prices would ease the current pain of Alberta and Saskatchewan but they would need access to more pipelines in order to fully benefit. • Higher oil prices would have a negative impact on Ontario’s manufacturing industry as prices for inputs into manufacturing would increase. • Canada’s consumers would also have to pay more for energy and gas. This could dampen overall consumer spending. • This may potentially drive inflation higher. Interest Rates While Trump’s election resulted in an immediate increase in U.S. government bond yields to just over 3 percent from 2.23 percent in July, it’s unlikely the Fed will ‘rock the boat’ prior to receiving real guidance from the new administration on its fiscal policy. Accordingly, we are not expecting to see large interest rate movements in the short term. However, over the life of the Trump administration we expect to see longer term interest rate rises, with a potential for the increases to be significant, for three reasons: • Trump repeatedly stated that he is not happy with the Fed’s current policy of low interest rates. We think it is very likely that when the current Fed chair finishes her term in January 2018, Trump will likely nominate a more interest-rate hawkish chair. • The U.S. economy is recovering from the last recession and employment levels are rising to effective full employment. This has led to recent wage gains at levels not seen since the 2008 recession. • Trump’s plan to invest heavily in infrastructure ($8 trillion) over the next 10 years is a likely catalyst for inflation and higher interest rates will result. 3 “Trump's oil policy will be relatively easy to implement and he probably will act quickly. While it's positive for U.S. producers it's net negative for Canadian producers as increased American production will introduce a cap on prices and limit export potential. In this environment, adding pipeline capacity is crucial. I think we are going in that direction.” Benjamin Tal, Deputy Chief Economist, CIBC World Markets Inc. November 2016 6 What do higher interest rates mean for Canada? • Canada’s interest rates are expected to rise in the longer term, as our interest rates have to eventually follow the U.S. to enable the Canadian Government to continue borrowing. • A weakened outlook for the Canadian dollar in the short term due to the prospect of U.S. interest rate hikes and trade uncertainties, coupled with a Canadian economy that is weaker than the U.S. economy. • If or when Canadian interest rates increase, this would negatively impact consumer spending in general, and the real estate market specifically, as mortgage payments would increase resulting in less income for discretionary spending as well as reducing the attractiveness of buying real estate. • There is potential for this to negatively affect the Federal Government. The Trudeau government aims to invest heavily in infrastructure in Canada. When interest rates rise, the cost of borrowing money for these investments will increase which in turn means that the government may not be able to fully implement all planned investments. This may encourage the Government to increase its reliance on partnerships with the private sector. • The impact on Canadian banks will be mixed. Canadian banks have high exposure to mortgages and consumer debt which would be negatively affected if higher interest rates lead to higher defaults. On the plus side, Canadian banks would profit from rising rates as borrowing margins tend to increase in an era of increasing interest rates. Ultimately, the net effect would depend on the severity of any real estate correction event. “…it’s too soon for the central bank to factor Donald Trump’s election win into its decision making… I’m of course aware that a number of things were said during his campaign, but we’re not in a position to take them on board or build them into our thinking until they actually occur.” Bank of Canada Governor, Stephen Poloz, November 28, 2016 7 Lower tax rates Trump has stated that he intends to reduce the corporate tax rate from 35 percent to 15 percent as stimulus to keep businesses in the U.S. as well as attracting companies back from foreign jurisdictions. He also intends to simplify the personal tax system by going from seven brackets to three and reduce personal tax rates. The highest rate would drop from 39.6 percent to 33 percent. It is worth noting that at 35 percent, the U.S. corporate tax rate is the highest among the 34 industrialized nations of the OECD. Evidence shows business investment does not respond in any significant way to a corporate tax reduction in another jurisdiction. However, tax as one consideration in a multitude of other investment considerations, including changes to repatriation taxes, may, on the margin, contribute to different investment decisions for globally integrated companies. Currently the U.S. taxes profits that are repatriated to the U.S. from foreign subsidiaries and provides a tax credit for foreign taxes already paid on that income. Since the U.S. has one of the highest corporate tax rates, repatriating capital to the U.S. results in additional taxes under the current regime. As a result, many U.S. multinational corporations are currently looking for ways to redeploy capital offshore rather than repatriate to the U.S. What do lower U.S. tax rates mean for Canada? • Sectors that are not location dependent and are highly mobile (e.g. high tech, bio-tech), may be affected by this relative change, combined with other advantages that the U.S. is offering to those sectors; it may change the cost-benefit equation for some companies who may consider relocating. • The potential for a “brain drain” affecting skilled persons that these industries require may be exacerbated if both corporate and personal taxes in the U.S. decline. • Tougher competition for capital due to looser U.S. regulatory environment and lower corporate tax rates. • Reducing the additional U.S. tax on foreign funds repatriated to the U.S. may decrease the capital left in Canadian subsidiaries of U.S. multinationals to invest in Canada or in foreign operations/investments. In addition, this may also lead to a draining of cash from Canada, which may impact the Canadian dollar and/or Canadian interest rates. • Trump’s platform considers removing the ability to deduct any interest expenses for tax purposes, which would be a significant change to the tax regime. This change may increase the cost for Canadian corporations acquiring U.S. businesses or expanding into to the U.S. • Some sectors in the Canadian economy that stand to benefit from the expected infrastructure boom in the U.S. may face non-tariff trade barriers as a result of a protectionist policy by the U.S. – still an unknown. This could result in some companies finding the combination of circumventing such trade barriers and benefiting from low corporate taxes a large enough incentive to move some or all of their operations to the U.S. 4 8 Infrastructure As noted above, a Trump administration is likely to invest heavily in U.S. infrastructure. This will contribute to economic growth in the U.S. – at least in the short term – which would increase U.S. consumer spending. What does U.S. infrastructure investment mean for Canada? • Canadian resource and commodity industries could gain from Trump’s wide-reaching, ambitious infrastructure spending plan and the consequential commodity demand – in particular the steel industry, the non-metallic mineral industry and the manufacturing industry. Trump’s plans may also reinvigorate stalled or delayed projects like the Keystone XL pipeline and the Gordie Howe International Bridge connecting Windsor and Detroit. In addition, the economic stimulus and subsequent rise in consumer spending that would be created through (albeit temporary) job creation could also lead to more consumer staple and consumer discretionary imports from Canada (changes to trade agreements notwithstanding). Transporting goods out of Canada and into the U.S. could also create higher shipping volumes in Canada and corresponding increased labour demand. • This being said, Canadian companies that could benefit from a construction boom in the U.S. should plan for the possibility that the Trump administration would expand current non-tariff barriers as noted above. Congress may very well support Trump, whose policies could limit the benefits available to non-American companies. For example, under the current ‘Buy American’ act, construction projects under $10,000,000 must be given to U.S. companies. • An Infrastructure Bank is being considered by Trump, which would leverage private-sector capital to finance construction, repaid by user fees or government payments; this repayment model is already popular across Canada. A broad spectrum of Canadian companies with experience in alternative financing and procurement and Public-Private Partnerships may also benefit from opportunities south of the border. Canadian companies teamed with American ones can form best-in-class consortia to provide invaluable experience. • America’s creditors also wield substantial authority over public spending proposals. As previously mentioned, Treasury yields surged in early November as a reaction to fiscal spending speculation, in part due to fiscal expansion expectations and faster than anticipated inflation. Trump’s infrastructure plans (not unlike Canada’s) have been designed for a long-lived low-interest environment. If investors’ concerns grow about the amount of federal spending, high borrowing rates could cause the Trump administration to shift priorities and focus on deficit reduction instead of stimulus through monetary expansion; Canada’s federal government could very well be forced to follow suit. 5 © 2016 PricewaterhouseCoopers LLP, an Ontario limited liability partnership. All rights reserved. PwC refers to the Canadian member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. December 2016. Views contained in this document are accurate at time of publication 9 We acknowledge that there are many issues to consider in light of this historic U.S. Presidential election. The ones we’ve chosen to highlight in this paper are those we anticipate to likely have the most impact on the Canadian economy. While we cannot predict with absolute certainty what will unfold over the coming months and years, we believe that some of Trump’s election promises will be tempered once he is in office and transformed into policies that reflect the realities of our inter-connected world and the role the United States plays in it. These are the sectors we believe should be closely monitoring announcements emanating from the new administration over the coming weeks and months. There are a considerable number of variables and unknowns and the situation is very fluid. Real Estate Companies should strengthen their balance sheet and be selective about new investments. Those involved in Public Private Partnerships (P3) could benefit from higher financing costs to the government. This last point also applies to construction companies involved in P3s. Companies that can benefit from an infrastructure boom in the U.S. should engage in strategic planning to assess ways to capitalize on the infrastructure boom. Among others, they should consider the possibility of acquisition, joint venture or expansion into the U.S. Lumber & Livestock– Producers should look to Asia to increase exports to offset potential for higher U.S. import tariffs. Energy Companies – Intensify efforts to reduce production costs, especially in natural gas, while meeting carbon reduction targets. Work with governments to open new markets for natural gas. Governments- Increase efforts to promote innovation in new industries and technologies to respond to the impact of labour and investment changes for existing industries.