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Global Trade At A Crossroads: USMCA, NAFTA's Successor

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Global Trade At A Crossroads: USMCA, NAFTA's Successor

The United States Mexico Canada Agreement (USMCA), intended to replace the North American Free Trade Agreement (NAFTA), is significant mainly for what it avoids--sweeping trade restrictions and likely economic damage to the three countries involved. We believe that its effects will be modest in most cases, raising the cost of some cars and SUVs sold in the U.S., but not materially changing the complex web of economic interdependence among the three North American countries or credit quality of most industrial and transportation companies that we rate.

The treaty, which must be ratified by each country's legislature, tightens existing restrictions on North American vehicle content necessary to qualify for tariff-free movements within the trade bloc, and introduces new requirements for manufacturing in high-wage factories (in effect, those in the U.S. and Canada), as well as quota limits on how many vehicles can be exported tariff-free into the U.S. We believe that these requirements will raise manufacturing costs and vehicle prices modestly over time, but the effect will vary among automakers, depending on how much they export vehicles from Mexico into the U.S. and the characteristics of their Mexican operations and supply chain.

The effect in other potentially affected sectors, such as agriculture and transportation, is rather less, largely maintaining the status quo and, in a few cases such as dairy exports to Canada, opening up new trade opportunities. Charts 1, 2, 3, and 4 show the overall mix of exports and imports by product categories for trade between the U.S. and its northern and southern neighbors in 2017. Notably, transportation equipment (mostly autos and auto parts) is the largest category in three of the four trade flows, and the second largest in the fourth trade flow. Some products, such as lumber exported from Canada into the U.S., are governed by other trade rules.

Limited Effect For The U.S. Economy, In Line With Expectations

Our economists expect the USMCA to have minimal impact on U.S. growth and employment. This reflects both the new agreement's terms and the fact that foreign trade represents a relatively small portion of the huge U.S. economy. Overall, the revisions to NAFTA were modest and in line with our expectations. We had assumed in our base-case scenario that negotiations would eventually lead to a trade agreement that largely preserved cross-border trade and investment links between the U.S., Mexico, and Canada. On the positive side, the USMCA eliminated the downside risk from a "no deal" situation and the prospect of prolonged uncertainty that could have undermined investment. However, changes to automotive rules of origin and increased regulatory compliance could potentially raise costs, making U.S. automakers less competitive globally and adding to inflation. The trade agreement still needs to be ratified by Congress, which will likely not happen until early next year after the November mid-term elections.

While USMCA eases some trade policy concerns, it only does so on one front. We continue to focus on the risk that U.S.-China tariff disputes escalate into an all-out trade war that spreads to non-tariff barriers and hurts confidence. The threat of 25% tariffs on auto and auto parts imports (from outside of Mexico and Canada) remains as well.

USMCA Will Bring More Certainty To Mexico's Corporate Sector

If the USMCA is approved, Mexico's corporate sector may benefit from a better trade environment and restored investor confidence. However, we don't see meaningful short-term implications for Mexican corporations, considering that the new agreement largely preserves the existing cross-border supply chains and trade framework, even under the gradual roll-out of new rules that will change the status quo. Still, for Mexico the trade deal could boost investment, improve business confidence, and reassure consumer sentiment.

Some of the more important changes to the trade framework will affect the auto industry, which in 2017 represented about 25% of Mexico's total exports, mostly going to the U.S. market. Mexican auto suppliers that we rate have a material exposure to the USMCA region--some companies derive 55%-60% of their business from North America, while others have exposure close to 90%. In all cases, we consider that rated Mexican auto suppliers are well positioned to remain highly competitive, and we expect that any incremental costs to comply with the new trade rules will not erode current margins. Going forward, competitive advantages should remain, driven by a high level of skilled labor and high-end technology to help meet automakers' quality and safety standards, while the geographic proximity to the U.S. market will continue to benefit logistics activities.

A year ago we indicated that consumer-driven industries were probably the most exposed to short-term risks if the trade agreement was not renegotiated. But following the presidential elections in July, Mexico's consumer confidence index reached a 10-year high. If the deal is ratified it could reinforce this positive consumer sentiment and therefore improve business conditions for consumer product and retail companies. In addition, sustained growth in consumer credit, record-high remittances, and a low unemployment rate in Mexico could support growth in this market.

In general, the certainty that the trade deal brings should restore investment flows into Mexico's corporate sector. As business conditions gradually improve, particularly in export manufacturing industries, we expect incremental capital investments in technological enhancements and capacity expansions.

Canada Retains Tariff-Free Access To Its Largest Export Market

The USMCA has both positives and negatives for Canada, but it preserves most of the trade and investment links with the U.S. (Canada's largest trading partner) so we aren't changing our baseline macroeconomic assumptions. We see Canadian investment spending lifting growth as businesses retool their production platforms and address growing capacity constraints. These investments could lift lagging productivity growth above its long-term trend of 1%, keep a lid on inflationary pressures, and allow the economy to sustain growth above 2%. Although households are carrying large debt burdens and higher interest rates are undercutting debt affordability, falling unemployment and wage growth is supporting consumer purchasing power. For now, we assume Canadian GDP growth will continue to average close to 2% through 2020. Since the USCMA mostly preserves, rather than extends, market access for Canadian exporters, we're likely to see little impact on the Bank of Canada's monetary policy decisions. We continue to expect one more rate hike in 2018 and three more next year that would see the central bank's policy rate exit 2019 at 2.5%. Tit-for-tat retaliatory tariffs and potential impacts on global trade from escalating U.S.-China trade tensions are likely to have a larger impact on Canada's economy over the near-term than changes associated with the NAFTA renegotiation.

The USMCA rules for autos will be a mixed bag for this important component of trade (shipments of motor vehicles and parts account for about 20% of Canada's total exports annually). A new export cap on passenger cars and SUVs is set well above what Canada currently exports annually, which means the new rules won't stymie growth for Canadian automakers. Agreeing to the cap helped Canada win an exemption from tariffs that could still hit European and Asian automakers if the White House goes ahead with its proposal to apply 25% duties on auto imports. U.S. tariffs on Canadian steel and aluminum haven't gone away yet though, saddling producers and consumers with higher costs.

Other changes in the USMCA will affect Canadian industries where export shares (and potential GDP impacts) are much lower. Canadian negotiators staved off American demands for Canada to dismantle its supply management policies, but they agreed to give American dairy farmers access to a larger 3.6% share of sales in Canada's domestic dairy market (up from 1%). Canada also relaxed previous regulations limiting imports of U.S. milk products used in cheese production, and it will also allow more poultry and egg imports. Greater competition from imports could displace domestic production for Canadian farmers, but also drive innovation and efficiencies that reduce costs. In other areas, negotiators made concessions on intellectual property rules that will extend Canada's copyright protections over 70 years (up from 50 years). In the pharmaceutical industry, biologic drug producers will benefit from a longer 10-year period before generic drug alternatives may be produced (previously eight years).

NAFTA's so called Chapter 19 dispute settlement mechanism will carry over into the renegotiated USMCA largely unchanged. It preserves the right for member countries to challenge each other for being unfairly targeted with anti-dumping or countervailing duties by another USMCA member. This mechanism requires trade disputes to be settled by an expert panel with representation from both countries involved in a dispute and offers USMCA members another option in addition to the World Trade Organization, for example to resolve trade disputes through a multilateral process. Canada used this provision a number of times to challenge U.S. duties against imports of Canadian softwood lumber. In those cases it took years, rather than weeks, to reach a settlement. As such, the Chapter 19 mechanism would not necessarily shield member countries from economic harm caused by tariffs that would remain in place until a final ruling is reached.

Autos Face New, But Manageable, Restrictions

Mexico and Canada are two of the largest vehicle exporters to the U.S., and trade negotiations between the three (especially between the U.S. and Mexico) focused on this industry. Industry consultant LMC Automotive Ltd. forecasts that Mexico will account for 32% of total imports of light vehicles into the U.S.--the leading share--in 2018 and Canada 20%, the third-largest behind Japan (see chart 5).

The new USMCA is broadly consistent with our previous base-case assumptions for the U.S. auto industry. The most potentially consequential changes are requirements that North American sourced content be 75% of the total value of a passenger vehicle, up from current 62.5% (plus separate rules for auto parts). This will limit automakers and their ability to source cheaper components that might be available from producers beyond North America's borders. Furthermore, 40% of assembly and certain other expenditures to produce a vehicle must be from "high-wage" ($16 or more per hour production wage) facilities to qualify for tariff-free trade. Mexico also signed on to new labor standards that will strengthen union membership and collective bargaining, which will set the stage for higher wages there. The cost of components that Canadian and American automakers source from Mexico, while less directly affected, could increase somewhat, and this could cause some rearrangement of supply chains.

However, the treaty limits (which have further, more detailed requirements) are phased in over time and, and for autos, the alternative to tariff-free is only a modest 2.5% tariff (with a much more substantial 25% for trucks). The caps on the number of imported vehicles from Mexico and Canada should not have material near-term effects, since the maximums (2.6 million autos and SUVs, but not pickups or heavy trucks) are about 40%-50% higher than current levels. Importantly, the agreement protects Canadian and Mexican vehicle exports into the U.S., up to the cap levels, from potential future auto tariffs levied by the U.S. more broadly (such as the threatened 25% tariff that could affect imports from other countries globally).

In our base-case scenario we had assumed that U.S. automakers would have adequate time to transition to the new rules. In our understanding so far, the agreement incorporates sufficient transition time (around four years). For example, for cars the new levels will likely phase in annually through January 2023, while for heavy trucks that runs through 2027. We expect a modestly negative (albeit manageable) impact on profitability as some automakers and suppliers bear costs to reshuffle the supply chain. This assumes higher production costs, the preservation of manufacturing for key components in the U.S. and Canada, and higher wages for Mexican autoworkers. Longer-term this could lead to more margin pressure for General Motors (GM) relative to Ford, given the company's higher truck imports from Mexico. Overall, we understand that Volkswagen A.G. relies the most on exporting vehicles from Mexico into the U.S., with GM, Renault-Nissan-Mitsubishi, and Fiat Chrysler relying less but still significantly on Mexican exports. The risk to automakers exporting from Mexico will also depend on whether their operations there already meet proposed content and wage rules. For example, most European and Asian automakers rely significantly on engines and components imported from overseas.

Agriculture Relieved At Outcome That Keeps Markets Open

With few changes for agriculture in the new agreement, the agribusiness sectors in Canada, Mexico, and the U.S. are likely breathing a sigh of relief. After all, these three trading partners make up just under a third of U.S. agriculture trade alone and are important players in global trade given that their aggregate GDP is near a third of the world's. In Mexico, the big win is in keeping fruit and vegetable exports flowing freely to the U.S., as well as beer. These two product categories make up just over half Mexico's agricultural and food exports to the U.S. Canada's large exports of feed and oilseed-related products to the U.S. will continue unhindered. But it's the U.S. agricultural sector that should be cheering, as it has been hit with tariffs and export restrictions from several nations in key commodities like pork and soybeans (which are not largely traded among North American partners), and would've possibly faced additional restrictions on corn and sweeteners if a new agreement hadn't been forged.

U.S. pork farmers and producers should be the biggest near-term beneficiaries from the agreement. U.S. pork exports had fallen nearly 20% year to date in 2018 to China and Mexico following tariffs levied by them. The agreement will bring much-needed relief by possibly lifting tariffs on Mexican pork imports from the U.S., just as the U.S. had ramped up production following the untimely addition of two new production facilities earlier this year. The U.S. Department of Agriculture (USDA) projects U.S. pork production to increase 3.5% year over year in 2018. Although producers have quickly found new markets for their new production, prices and processing margins had taken a big hit. Average hog prices traded on the Chicago Board of Trade were down nearly 30% before rebounding nearly 20% since the announcement. Average pork cut-out margins (the margin processor earn from processing live animals into lean meat) were down 23% so far in 2018, based on data provided by Bloomberg, but are now trending higher. This agreement keeps a key export market open for U.S. pork and should provide price support to help alleviate margin pressure.

The corn and corn-based sweeteners market also dodges a bullet with this agreement. Based on USDA data, Mexico is the third-largest global importer of corn and imports about a quarter of U.S. corn exports. With U.S. farmers already hurting from lower soybean exports due to Chinese tariffs, they will likely shift more acreage back to corn next year, so having a trade agreement that keeps open an important corn export destination is a welcome development. U.S. high fructose corn syrup (HFCS) manufacturers also rely on Mexican imports of the corn-based sweetener to remain profitable. Just under a third of Mexican sweetener consumption comes from HFCS, the vast majority of which it imports from the U.S. If Mexico shifted more consumption of sweetener back to refined sugar instead of importing cheap U.S. HFCS--a very plausible scenario given Mexico's domestic sugar production and low global sugar prices--the U.S. would likely be closing HFCS plants to remain profitable.

While dairy was a sticking point in the negotiations between the U.S. and Canada that could have derailed the agreement, the near-term impact of opening the dairy market between the U.S. and Canada will not likely be material because domestic demand consumes the majority of milk production in both regions. Based on USDA data, we estimate that U.S. domestic consumption makes up over 80% of total production. Moreover, most dairy exports constitute milk powder (largely to China) and the global market has been battling continued bouts of excess supply ever since the European Union deregulated its dairy industry. Accordingly, it's unclear how much the dairy trade will pick up between these two trading partners given still-weak pricing in the global market and significant domestic consumption in both countries.

Steel And Aluminum Tariffs, Not USMCA, Are The Key Issue For Metals

Tariffs on steel and aluminum for Canada and Mexico will remain even after the USMCA has been ratified. These U.S. Section 232 tariffs, widely viewed as a lever for other trade negotiations, are predicated on a threat to U.S. national security, effectively sidelining these key metals from the NAFTA framework before negotiations even started. All told, six months of Section 232 tariffs and their retaliatory measures have barely registered in credit ratings, despite the high-profile initiation of trade actions in early 2018.

Favorable credit momentum exists for some U.S. integrated steel producers, partly because of tariffs, but we've also upgraded opponents of trade barriers, while some supporters downstream are feeling a cash flow squeeze amid rising costs. U.S.-based steel producers are investing windfall cash flows to boost productivity and profitability, allowing companies to take advantage of the country's natural endowments of iron ore and metallurgical coal. On the other hand, we don't expect these investments will significantly expand U.S. steel output, mostly because global capacity well exceeds demand, and is mostly supplied from large, modern, low-cost mills.

Tariffs would only affect ratings in the U.S. primary and downstream aluminum segments if they fundamentally improve the profitability and cash flows of producers' large, fixed asset bases, which appears unlikely given the comparative advantages of producing primary metal in other countries to feed value-added manufacturing in the U.S. Only a few primary aluminum facility restarts in the U.S. have even been posited because the competitiveness of aluminum smelters depends heavily on large amounts of readily available, low-cost electricity from sources like hydropower in Quebec, Scandinavia, and Russia or natural gas in the Middle East. Even with a 10% tariff, most mothballed smelters in the U.S. remain structurally uncompetitive because of comparatively high operating costs and significant capital requirements for restart and catch-up.

U.S. tariffs on steel and aluminum imports may support domestic U.S. output for primary producers, but the tariffs are also pressuring costs for downstream operators like service centers, rolled products, and engineered products. Metals consumers are contending with higher costs for imported and domestic metals, and even considering moving domestic manufacturing to lower-cost countries to avoid tariffs. For example, about three-quarters of the aluminum consumed in the U.S. is supplied by Canadian smelters, so many buyers are compelled to accept tariff pass-throughs because there's insufficient primary aluminum in the U.S. to fill the gap, and little incremental capacity is likely.

Railroads Should Remain On Track

North American freight transportation companies, like many of the industries they serve, are relieved that the proposed treaty largely preserves existing regional trade flows. The most closely involved are railroads, which carry large amounts of cross-border trade and in some cases (notably Kansas City Southern, Canadian National Railway Co., and Canadian Pacific Railway Ltd.) operate in two countries. Important rail-borne trade includes finished autos and auto parts between the U.S. and its two neighbors, grain exports from the U.S. to Mexico and between the U.S. and Canada, paper and forest products from Canada to the U.S., and U.S. exports of refined products and petrochemicals. The treaty changes affecting the auto industry could, over time, lower the volume of auto-related shipments on the railroads modestly, but this would likely be more in terms of foregone future upside than material reductions from current levels.

Kansas City Southern, which owns a medium-sized railroad in the central U.S. and the largest Mexican railroad (which runs from Texas to Mexico City and other destinations), probably has the most at stake. Its operations are split about equally between the two countries and more than one-third of its traffic is cross-border. Grain (mostly corn) exports to Mexico and auto-related products in both directions are major traffic categories. We believe the proposed new trade arrangements and the new incoming Mexican president will not likely damage Mexico's economic prospects nor those of its corporate sector, which should avert material risks to Kansas City Southern's operations in that country. We revised our rating outlook on Kansas City Southern to positive from stable in February 2018, citing a solid financial profile that mitigates risk from any materially adverse outcomes in trade negotiations. U.S.-based Union Pacific Corp. owns a minority stake in the second-largest Mexican railroad, Ferrocarril Mexicano, S. A. de C. V. (Ferromex), and interchanges with that rail system at various locations along the border. Canadian National owns the former U.S. rail company Illinois Central, whose tracks run from Chicago to New Orleans, with cross-border freight more than a third of its revenue. Similarly, Canadian Pacific Railway's exposure to cross-border traffic is meaningful at 31%, although its volumes are much smaller. Automotive revenues for both players, while only 6%-7% of total freight revenue, are largely derived from the U.S. and could potentially be affected longer term if quotas are exhausted. Other transportation modes, including trucking and package express, are more significant in U.S.-Canadian trade than U.S.-Mexico, and share an interest in continued trade flows.