NAFTA Where Do We Stand?

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1 Luis Alvarado Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS NAFTA Where Do We Stand? July 17, 2018 Key takeaways» Concerns about international trade have been mounting of late as trade war rhetoric captures headlines. We believe the most likely scenario outcome (70% probability) is for a prolonged negotiation between the U.S. and its trading partners aimed to level the playing field by making reciprocal and fair agreements. The Trump administration has stated it will not sign an agreement until after the midterm elections.» We believe recent tariffs on steel and aluminum on Canada and Mexico are negotiating tactics to create pressure. These measures are not intended to abolish free trade but instead to fix damaged trade policies and renegotiate deals that align with the interests of U.S. workers and investors. What it may mean for investors» A solid U.S. economy coupled with fiscal stimulus should continue to support consumer demand and most likely increase import volumes. Until a deal is struck, we believe that the administration s macro policies are unlikely to reduce the trade deficit. Meanwhile, rising tariffs and trade-related restrictions could add to equity market volatility in the near term. Concerns about international trade have been mounting of late as trade war rhetoric captures headlines. Investors are questioning whether the tariffs are a deliberate negotiation tactic, and if so, what is the goal of the U.S. administration? We believe the most likely scenario outcome (70% probability) is for a prolonged negotiation between the U.S. and its trading partners aimed to level the playing field by making reciprocal and fair agreements. In this week s report, we will focus on the North American Free Trade Agreement (NAFTA) and the U.S. s trade relationships with Canada and Mexico. Last week, we published a report on the newly elected Mexican president and some initial thoughts on the current state of the NAFTA negotiations. On the day of the Mexican election (July 1), in a televised interview, President Trump mentioned that he was unhappy with the revised NAFTA deal and that he does not want to sign any new agreement until after the midterm elections in November. For now, it appears that talks remain on hold; however, we believe it is important to review how we got here and understand the near-term implications for the economy and investors Wells Fargo Investment Institute. All rights reserved. Page 1 of 5

2 A brief walk down memory lane Since its proposal, NAFTA had bipartisan support conceived by Ronald Reagan, negotiated by George H.W. Bush, and passed through Congress by Bill Clinton with support from congressional Republicans and U.S. corporations. Initially, the proponents for the trade agreement argued that it would propel U.S. job growth while helping to alleviate the flow of undocumented workers across the southern border. The agreement came into effect on January 1, At the time, the U.S. held a trade surplus with Mexico of $1.6 billion and a deficit with Canada of $10.8 billion. Chart 1. U.S. trade balance with NAFTA partners Billions of dollars Canada Mexico Source: FactSet, December 31, Notes: Census basis, trade in goods only. Yearly data, not seasonally adjusted. Twenty-four years later, the U.S trade balance with its NAFTA partners, Mexico and Canada, has deteriorated since the inception of the agreement (more dramatically with Mexico). Also, it appears that the U.S. jobs promised did not materialize as expected. It is estimated that NAFTA directly cost the U.S. a net loss of approximately 500,000 to 700,000 jobs 1 (mostly manufacturing jobs in automotive, textile, computer, and electrical appliance industries); however, other sources claim that it has actually benefited manufacturing jobs to a figure of 800,000 after the signing of the agreement. 2 It appears that trying to find NAFTA s role in regards to jobs comes down to where economists and researchers stand in the political spectrum and the assumptions they use in their studies. What they can agree on, however, is that the surplus with Mexico has turned into a chronic deficit. 1 Economic Policy Institute NAFTA Twenty Years After: A Disaster, January U.S. Chamber of Commerce The Facts on NAFTA: Assessing Two Decades of Gains in Trade, Growth and Jobs, March Wells Fargo Investment Institute. All rights reserved. Page 2 of 5

3 Why renegotiate now? From the U.S. administration s perspective, the scale on jobs and expected benefits from NAFTA have turned sour for the U.S. relative to its trading partners over the life of the agreement. On the campaign trail, then-candidate Trump blamed NAFTA for the loss of manufacturing jobs in key states and promised he would renegotiate a better deal or abandon the agreement altogether. We believe recent tariffs on steel and aluminum on Canada and Mexico are the beginning of negotiating tactics to create bargaining pressure. These measures are not intended to abolish free trade but instead to fix damaged trade policies and renegotiate deals that align with the interests of U.S. workers and investors. At first glance, it appears that there are three central issues from the U.S. administration s side that need to be ironed out before the signing of a new agreement: 1. Trading of automobile vehicles: Under current NAFTA rules, at least 62.5% of a car needs to be sourced from the three countries in order for it to be traded tarifffree. The U.S. negotiators initially wanted to raise it to 85%; it is said that they eventually came down to 75%, but details remain unclear. 2. Dispute resolution: Two current NAFTA provisions to settle disputes are being challenged. Panels are created to review complaints of underpriced product trading (known as dumping) and also disputes between a corporation and a government. The U.S. administration wants to eliminate them, while Canada and Mexico have said it is necessary to keep the panels. 3. Rescission of Agreement clause: The U.S. wants to add a clause specifying that NAFTA expire in five years unless the three countries agree to extend it. It appears negotiators are settling on some kind of nonbinding periodic review. Investment implications The U.S. economy remains on solid footing. Gross domestic product (GDP) is expected to expand 3.4%, quarter-over-quarter seasonally adjusted annual rate, in the second quarter as the unemployment rate hovers around 4%, the lowest level since the year New job openings continue to outpace new hires while wages continue to rise, albeit at a slower pace than before the financial crisis. The U.S. housing sector is in good shape, and consumer and business confidence remain elevated. All these factors coupled with fiscal stimulus should continue to be positive for consumer demand and most likely cause import volumes to grow. At the same time, the expanding economy will prompt further action from the Federal Reserve. Rising interest rates could lead to a stronger dollar, which would result in a wider trade deficit (all else equal). We believe this outcome is counter to what the administration seeks to accomplish. For now, an increase in tariffs appears more damaging to corporate America than to U.S. consumers and the U.S. economy as trade is a fairly small component of U.S. GDP. However, international trade represents a large share of multinational companies that compose the S&P 500 Index. Until a renegotiated deal is achieved, we believe the administration s macro policies are unlikely to reduce the trade deficit. Meanwhile adopting tariffs and trade-related policy restrictions could definitely add to equity market volatility Wells Fargo Investment Institute. All rights reserved. Page 3 of 5

4 Economic Calendar Date Report Estimate Previous 7/17/2018 Industrial Production MoM 0.50% -0.10% 7/17/2018 Manufacturing (SIC) Production 0.50% -0.70% 7/17/2018 Capacity Utilization 78.30% 77.90% 7/17/2018 NAHB Housing Market Index /17/2018 Total Net TIC Flows -- $138.7b 7/17/2018 Net Long-term TIC Flows -- $93.9b 7/18/2018 MBA Mortgage Applications % 7/18/2018 Housing Starts 1322k 1350k 7/18/2018 Housing Starts MoM -1.90% 5.00% 7/18/2018 Building Permits 1328k 1301k 7/18/2018 Building Permits MoM 2.00% -4.60% 7/18/2018 U.S. Federal Reserve Releases Beige Book 7/19/2018 Initial Jobless Claims 220k 214k 7/19/2018 Continuing Claims k 7/19/2018 Philadelphia Fed Business Outlook /19/2018 Bloomberg Economic Expectations /19/2018 Bloomberg Consumer Comfort /19/2018 Leading Index 0.50% 0.20% 7/23/2018 Chicago Fed Nat Activity Index /23/2018 Existing Home Sales 5.42m 5.43m 7/23/2018 Existing Home Sales MoM -0.20% -0.40% 7/24/2018 FHFA House Price Index MoM % 7/24/2018 Markit US Manufacturing PMI /24/2018 Markit US Services PMI /24/2018 Markit US Composite PMI /24/2018 Richmond Fed Manufact. Index Source: Bloomberg as of July 13, Wells Fargo Investment Institute. All rights reserved. Page 4 of 5

5 Risk Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR Wells Fargo Investment Institute. All rights reserved. Page 5 of 5