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The Trade Deal Formerly Known as NAFTA

Wells Fargo Investment Institute - October 4, 2018

Key takeaways

  • Trade negotiations between the U.S., Canada, and Mexico successfully concluded on September 30.
  • The outcome represents an updated trade agreement that is intended as an acknowledgement of the evolution of global trade over the past 20 years.

What it may mean for investors

  • We believe the new agreement is generally a market-positive outcome. We expect the conclusion of NAFTA negotiations to support capital spending broadly and support the U.S. auto industry more specifically. We believe that some industrial, transport, and consumer staples firms could also benefit from the new deal.

Download the report (PDF)

What happened?

Negotiations concluded late on September 30 as Canada agreed to join the U.S. and Mexico in the new United States-Mexico-Canada Agreement (USMCA), the next iteration of the North American Free Trade Agreement (NAFTA). After more than a year of negotiations, this agreement is intended to update and ultimately replace NAFTA as an acknowledgement of how trade between the three countries and globally has evolved since its foundation. For example, global supply chains and advances in technology have fundamentally changed how goods and services are packaged and sold around the world over the past 20 years; however, governance around trade has only changed slightly—the USCMA is an attempt to fix that.

What’s changed?

We summarize the changes in Table 1 below, but generally speaking, the USMCA addresses trade-related concerns with respect to the auto industry, intellectual property, and liberalized market access for U.S. farmers. The agreement also resolves questions about the trade dispute resolution framework and introduces a provision to allow ongoing reevaluation of the trade agreement.  

Key changes in the rules of origin for auto parts and assembly were already included in the agreement between the U.S. and Mexico. The main outstanding issues between the U.S. and Canada dealt with access to the Canadian dairy market and resolution of disputes between the nations. Both sides made concessions and were ultimately able to reach a final agreement. The U.S. was granted greater access to the Canadian dairy industry in exchange for agreeing to Canada’s position on leaving the dispute resolution process unchanged. While not a topic of concern, an outcome from the USMCA was an agreement among the three countries to not engage in competitive devaluations of their currency. 

Table 1. The results of successful negotiation


IA_NAFTA_image_1.png

Sources: Wells Fargo Investment Institute, Bloomberg, White House, October 1, 2018.

In terms of current and proposed tariff actions, the U.S. gave its assurance that Mexico and Canada would be exempt from higher tariffs on auto exports if the U.S. decided to implement them broadly. Tariffs related to steel and aluminum exports to the U.S. nevertheless remain in place for Canada and Mexico as the resolution requires a track separate from NAFTA negotiations. However, this is expected to be resolved shortly as USMCA talks conclude. 

More broadly, the USMCA serves as a potential template for future agreements as the U.S. administration engages the European Union (EU), Japan, China, and others in trade talks. More to the point, the administration has explicitly referred to the agreement as a three-pillared paradigm-shifting model intended to address 1) fairness in trade, 2) intellectual property protection, and 3) state intervention in free markets.

When will these changes take effect?

The agreement was reached just in time to meet the U.S. and Canada mutually agreed upon deadline of September 30. This allows for the required 60 days for review and signing by all three leaders before heading to each country’s legislatures for review and approval. There is a potential that the U.S. Senate could vote on the agreement in the lame duck session following the November midterm elections, but the likeliest outcome is that Congress will vote on the USMCA next year. 

The successful inclusion of all three countries in the final agreement is important due to the economic interconnectedness that has developed over the last 20 years. Furthermore, an agreement excluding Canada would be more difficult to pass through Congress. With Congress expected to pass the deal, most of the key changes could likely take effect as soon as 2020. Until then, trade provisions under NAFTA are expected to remain in force.  

How will this affect the U.S. economy and markets?

We view the overall changes to the trade deal as broadly cosmetic, as the announced USMCA is largely similar to NAFTA. U.S. market reaction to trade actions has been muted as market participants mostly priced in the agreement’s resolution following the successful completion of the U.S.-Mexico leg of negotiations. International market response, on the other hand, was more spirited. This was particularly reflected in the Mexican peso and Canadian dollar rally on the news. From an economic perspective, we believe that successful resolution of NAFTA negotiations reduces trade related uncertainty and provides clarity for business leaders that encourages capital spending decisions, and, ultimately, economic activity.  

At a more granular level, the biggest changes include higher rules of origin requirements for the auto sector. We believe the long-term “winners” will be companies in the automation and robotics space—largely companies that are part of the Industrial sector. The agreement stipulates that at least 30% of cars (rising to 40% by 2023) must be made by workers earning at least $16 an hour—about three times the typical manufacturing wage in Mexico now. USMCA also stipulates that Mexico must make it easier for workers to form unions. It is hard to identify how the new rules will be enforced. We view accelerating automation in the auto manufacturing space as favorable. 

While Industrial companies should be the main beneficiaries, other companies levered to Mexico will likely also benefit. Some Consumer Staples companies, which have strong revenues from Mexico, should benefit as well as railroad companies that provide agricultural goods—like chicken, turkey, and eggs—markets in which Canada agreed to widen access. While U.S. dairy farmers will face lower tariffs in Canada, we believe this will have minimal impact on S&P 500 Index companies. Additionally, USMCA agrees to extend exclusivity for biologic drugs before generics can be produced. Exclusivity will be increased to 10 years in Canada from eight years, which is expected to be a positive win for the pharmaceuticals industry. Other changes, such as increased intellectual property protection and six-year review, should be positive for businesses but will likely have little direct economic impact in the near term. 

What’s next?

While the new USCMA will address trade with the U.S.’s two largest overall trading partners, trade with China remains the largest (and a growing) source of the U.S. trade deficit. The U.S. appears determined to seek changes in perceived unfair Chinese trade practices (e.g. forced joint ventures, theft of intellectual property) by continued application of tariffs and other measures, including coordinated efforts among developed economies at the World Trade Organization. 

We believe that successful trade negotiations with Mexico and Canada have provided a negotiating framework for ongoing discussions with the EU and Japan. Once the EU and Japan resolve their differences with the U.S., we believe that they could collectively concentrate pressure on China in a way that the U.S. alone cannot.