U.S. tariffs will put Canadian corporate spreads at risk

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Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

Pablo Martinez, portfolio manager, CIBC Asset Management 

There’s been major changes in the political landscape in North America in the past few months. And that has had many impacts on most markets, and also on the bond market. 

Most probably, a certain amount of tariffs will be imposed on Canadian exports to the U.S. And we also have to assume that following that policy, there will be counter tariffs that will be imposed on U.S. imports to Canada. Obviously, this has major impact because both economies are very well integrated. So there’s going to be impact, obviously, on inflation and on growth. 

So we have to determine for both countries which impact will be the strongest. 

In the U.S., the impact will most probably be firstly on inflation, which will probably lead to higher rates. We might call it tariffs, but this is a sort of taxation on consumers in the U.S. This can also create disturbance in the supply chain, because both economies are very well integrated. 

So the first impact in the U.S. will probably be on inflation. And then, if the policy is being maintained and tariffs are being imposed for a longer amount of time, then we’ll probably see the impact on growth in the U.S. 

As for Canada, a whole lot more of GDP is derived from exports. And most of our exports are going to the U.S. The main impact of tariffs and counter tariffs will not be on inflation. It will be on growth. So, we can expect Canadian yields to be affected downwards from inflation right off the start. 

As for corporate spreads, less integration for both economies will mean that corporate spreads will be at risk. We’ll probably see some kind of weaker spreads when the imposition of the tariffs is being started. 

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Whenever we are making expectations and forecasts for rates and for corporate spreads, we’re always looking for curveballs. Where are other risks lying? 

Considering the speed at which policy is being changed in the U.S. — and also in Canada — there’s a lot of curveballs out there.  

Obviously, the imposition of tariffs will have industry-specific impacts. For example, on the auto industry. If there’s tariffs being imposed on aluminum and steel, well, that’s going to make cars more expensive to be built. But at the same time, because the supply chain is so integrated, the imposition of tariffs may make it more difficult to get the end-product out of the assembly line. Maybe there’s less for sale, and prices are moving up. 

There’s also other industries, which will be affected. For example, the beverage industry, which is highly dependent on Canadian aluminum. This may make beverage more expensive. Transportation. If there’s tariffs imposed on oil, gas will be more expensive, making everything that’s being transported by truck more expensive. Also, spare parts may be difficult to find. So, a lot of industries are being affected by this. 

Another thing that we’re looking at is debt levels from government. We have heard that the Canadian government is at the ready to impose counter tariffs on U.S. imports to Canada. That being said, it will have an impact on Canadian businesses and also on Canadian consumers. And the government has been adamant that they will be there, at the ready, to help businesses and consumers lower the impact of tariffs on their everyday life. 

What does that mean? It means higher debt. 

And it really sounded a bit like what they had been doing during Covid. Emergency cheques to corporations and to individuals. That translated last time in higher consumer spending, and also on higher inflation. 

It also translated into a higher debt level. And that’s an issue. It’s an issue because we’re starting off already at high debt levels for both Canadian and provincial governments. 

To add to the complexity of all this, the Canadian government is prorogued, which means that if emergency help has to be set forth, it will be done primarily by provinces, which means that there might be an impact on the overall debt level from provincial bonds, and also that you might see spreads widening. 

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Whenever markets are volatile, for active managers it means opportunity. There is still opportunities that exist in investment-grade corporate bonds. We have to be very careful on which industry we’re looking at, and also which sectors were looking at. 

The first and foremost approach that we’re taking to this is obviously to favour U.S. corporate bonds here. As I said before, we believe that the U.S. will, in a trade war, fare relatively better than Canada at the onset. 

So, when there’s a trade war, both trading partners are suffering. The question is who’s suffering less? And in this case, most probably the U.S. will be suffering less. So, we would have a tendency to favour U.S. corporate bonds, and also favour Canadian bonds from corporations which have a high level of presence in the U.S. market. 

I’ll give you an example. If we want to increase our positions in Canadian banks, we might be favouring banks that have a higher percentage of profit from their U.S. branch. So that’s one thing that we are looking at. 

And, also, we have to realize that when tariffs are being announced, there is an immediate reaction from the industries which will be the most effected. We had an example last week when tariffs were announced, on car company bonds. Those have been affected quite dramatically. Those spreads came back once the threat of tariffs had been delayed. But still, those spreads are wider than what we have seen in the past months. And the chances are that they will be going wider. 

So what we are doing right now is playing it defensive. We have a lower weight in corporate bonds than we’ve had in the past few years. We want to have ammunition to be able to spend if we realize that the market is punishing corporations too much because of current threats of tariffs. 

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As for duration, we have seen a market which was very volatile — rates are moving up and down quite dramatically in the past few weeks — but we do still believe that rates will be, for the year, mostly trading in a range, a bit like we’ve seen last year. We saw that 10-year Canada bond trade in 100-basis-point range. We’ll probably see the same thing this year, but those moves will be much more volatile. 

And the reason why we believe that the range will be maintained is mostly because of the fact that there’s going to be a bit of a fight between higher rates, which will be caused by higher inflation from tariffs, but, at the same time, lower rates caused by lower economic growth. So that will be, first, yes, data dependent, but mostly news dependent. As news of tariffs are being announced and then delayed, we will see the market being very volatile. So we believe that the best way to approach this is being long when rates are moving up quite dramatically, to be able to play the range, and being shorter when the rates move down quite dramatically on bad news tariff-wise. 

As for sectors, we do believe that provincial bonds might be getting hit in the next few weeks because of the active tariffs and also the deterioration of their balance sheets — not only because we will see how packages from provinces, which will be expensive, but also economic growth might impact also revenues that are being collected via taxes by provinces and also by corporations. 

Corporate spreads will most probably be affected, but they will, after the initial spread widening from the announcement of tariffs, they will be good opportunities to buy in on weakness.

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