Canadian officials warned on January 10 of increasing likelihood that the United States would give six months’ notice of withdrawal from NAFTA. Negotiations have moved little in five rounds of talks with the sixth scheduled on January 23 in Montreal.

Renegotiating the 25-year trade old agreement was always going to be difficult. Trade between the three North American countries (the United States, Mexico, and Canada) tops $1 trillion and the prevailing business model in several industries is built around the cross-border agreement.

To make matters worse, political events this year could put up a roadblock to the negotiation process. 

The market is still optimistic that the three governments can avoid the cataclysm that would result from a complete scrapping of the agreement, but at this point it’s not looking good. 

#-ad_banner-#A termination of NAFTA could be the year’s biggest market mover and it will be tough finding winners in the fallout.

Will NAFTA Fall Apart?
Canada and Mexico have both rejected U.S. hardline requests of a five-year automatic termination clause, the elimination of dispute panels and stricter rules on auto and dairy. That has stalled negotiations and prompted many to believe President Trump may give the required six-month notice that the United States will drop out of the agreement.

Some believe the six-month notice could be used as a bargaining chip to speed talks, but it could also backfire.

Mexican officials warned the country would cease to negotiate if the United States gave notice of withdrawal. July elections in that country could make it difficult for leaders to take anything but a hardline stance on negotiations. For its part, Canada has filed a complaint with the World Trade Organization challenging the United States’ use of anti-dumping and anti-subsidy duties.

President Trump campaigned aggressively against NAFTA, but has largely held off on action while focusing on tax reform. Midterm elections and a July expiration of special trade powers given the President may cement his hardline stance, and odds are increasing that the trade deal falls apart.

Congress could move to stop termination of the trade pact if President Trump gives formal notice to withdraw. This would, however, require a bipartisan effort , which could be difficult to manage given midterm elections. 

With market attention on the potential threat from North Korea, NAFTA fallout could be the nuclear strike to hit stocks in 2018.

How The End Of NAFTA Could Affect The Economy And The Markets
Moody’s Analytics forecasts higher inflation and lower economic growth for all three countries if NAFTA is scrapped — with Mexico getting hit the hardest. Trade between the three countries tops $1 trillion, with the United States exporting over $500 billion to its two trade partners. Trade across the three countries has increased 258% in nominal terms since 1993.

A U.S. withdrawal wouldn’t mean the end of trade, but it would probably mean short-term pain before tensions bring the three countries back to the negotiating table. Sources inside the Mexican government tell Bloomberg that they will withdraw if notice is given and it’s unlikely that negotiations would start again until after the November midterm elections.

The consumer price index estimates that inflation rose a cumulative 65% from 1993 to 2016 while apparel prices fell nearly 8%, evidence of the trade pact’s weight on price in some industries. If the trade deal were to fall apart and import taxes increased, industries benefiting from the agreement could see prices surge.

That could set off a chain of inflation across retail. Prices are likely to increase quickly in the industries directly affected, especially in apparel and automotive. Higher prices here could force wage inflation and higher prices in other industries, as well as generally hit consumer sentiment.

The transportation and auto industries would be broadly hit by a cessation of negotiations and the potential of an end to NAFTA. Automotive parts supplier Lear Corporation (NYSE: LEA) saw its biggest share drop in six months when Canada warned of increased risk to the deal. Demand for rail and truck transportation could fall as companies shift manufacturing to localized plants.

The iShares MSCI Mexico ETF (NYSE: EWW) would likely see shares fall, as would the iShares MSCI Canada (NYSE: EWC). EWC sank by as much as 1% on the heightened risk of a U.S. withdrawal, while EWW plunged by more than 2% after the news. 

Both funds have lagged the S&P 500 over the last six months, with the Mexico ETF dropping 11% as negotiations have stalled.

It’s more difficult finding winners than losers if NAFTA negotiations fall apart. The price of gold and other precious metals would likely increase on higher inflation and as a hedge against the uncertainty. Gold closed out 2017 with a gain of 12.7% — its best year since 2010. The price of bullion has already jumped 2.2% in the first two weeks of the year on the potential for higher inflation and uncertainty. 

The biggest winners might not be sector-wide, but in mid-size and smaller companies who could benefit as larger rivals face higher tariffs on goods produced by their Canadian and Mexican manufacturing facilities. That could broadly help companies in the Russell 2000 Index of small-cap companies or those in the Russell Mid-cap Index. More specifically, companies in agriculture and manufacturing with domestic operations could benefit the most.

Risks To Consider: Negotiations can still turn around. Even a withdrawal notice doesn’t guarantee the end of NAFTA.

Action To Take: The potential death of NAFTA could be one of the biggest risks of 2018. Consider hedging the risk by avoiding some of the industries with most to lose while looking for beneficiaries in mid-size competitors.

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