NAFTA Exit Negative for U.S. Autos

During 2017, President Donald Trump’s administration made three major policy moves relevant to the U.S. auto industry.

The first came Jan. 23, when Trump pulled the United States out of the Trans-Pacific Partnership. We are glad he exited the agreement; we do not think TPP would have helped U.S. automakers gain meaningful market penetration in TPP countries such as Japan and Malaysia because Japanese automakers dominate many Southeast Asian nations, and we expect they would continue to do so even with TPP.

Japanese automakers would benefit more than American automakers because TPP calls for local content to make up only 45% of a vehicle, and Japan is geographically closer to low-cost Asian nations than are American automakers. This clause meant a vehicle could have been made in Japan with over half of its content from nations outside the TPP and still be sold in the U.S. tariff-free.

The second major policy move came in March 2017, when Trump visited Detroit and ordered the U.S. Environmental Protection Agency to reopen a midterm review of the emission rules that the EPA sets to coincide with the National Highway Traffic Safety Administration’s corporate average fuel economy, or CAFE, rules. The Trump administration will decide by April 1 if the original rules are appropriate; if they are not, the EPA will submit a new rule proposal for the 2022-25 model years for public comment.

The EPA under President Barack Obama made news after Trump’s election by finalizing greenhouse gas standards for the 2022-25 model years that equate to a fleetwide fuel economy average of 54.5 miles per gallon in 2025, which is roughly 40 mpg in real-world driving conditions. Under a 2011 agreement (finalized in 2012) among the automakers, the EPA, the California Air Resources Board, and the NHTSA, the auto industry agreed to a 54.5 mpg rule for the 2025 model year, provided there was a midterm review for 2022-25 model year rules. The rules for those model years were to be finalized by April 2018, and in July 2016, the government proposed rules in a draft technical assessment report that were slightly relaxed from 54.5 mpg by 2025 to 50.8 mpg, due to consumers heavily favoring light-truck models over sedans since the 2011 agreement. On Nov. 30, 2016, shortly after Trump’s election win, the Obama-led EPA drastically shortened the comment period for the midterm review so that the original 54.5 mpg for 2025 model year rules became final Jan. 13, 2017, before Trump took office.

Trump’s EPA chief, former Oklahoma Attorney General Scott Pruitt, is likely not a believer in global warming, nor is he a fan of broad federal power--he fought the Obama EPA often. We doubt Pruitt is a supporter of the strict CAFE rules imposed by Obama’s EPA, but undoing rules for the 2022-25 model years is not as easy as Trump issuing a decree. If the rules were rescinded, there would need to be a new set of federal rules, which would require a technical study and a lot of time, probably a couple of years. These rules would then have to go through a comment period process, and we suspect they would be fought in court by environmental groups and CARB, which will not want the Obama rules lowered. Although the Obama rules are tough, they are a national program, and the powerful CARB agreed in 2011 that the Obama rules would meet compliance with California rules for the 2012-25 model years. This is relevant because California is the largest vehicle market in the U.S. and because 12 other states--mostly in the West Coast and Northeast, including New York, which combined make up about 30% of U.S. new-vehicle sales per CARB--have adopted CARB rules as their own state’s rules.

In our view, removing the current CAFE rules would not accomplish the Trump administration’s goal of undoing cumbersome regulation put in place by Obama. It would create a patchwork of various degrees of state regulation, and California’s rules would effectively become the national standard because we believe that every automaker must meet California’s rules to compete in the U.S. (the state makes up about 12% of annual new-vehicle registrations). However, the EPA under Trump could revoke California’s waiver to set its own greenhouse gas emission rules for the 2009 model year and subsequent years. The EPA granted California this waiver in July 2009. A waiver revocation would probably start a long court battle between the state of California and the EPA, as Section 209 of the Clean Air Act allows California to set its own rules if the EPA gives a waiver. The EPA has granted a waiver to California many times over the past several decades. Pruitt said at a June EPA congressional budget hearing that the waiver is not under review.

Even if the EPA does not revoke California’s waiver, we see a states’ rights battle possibly going all the way to the U.S. Supreme Court, which has five of its nine justices selected by Republican presidents, if Trump’s EPA lowers the CAFE standards enough that CARB rejects the change, which we think CARB would do. Twelve other states have adopted California’s rules, so we see a messy court fight on the horizon, with the states wanting to set their own rules if Trump eases the existing rules. After the March EPA announcement of reinstating the midterm review, several state attorneys general said they will fight a CAFE revision in court. Environmental issues are very important to lawmakers in the state of California. The president of the California Senate, Kevin de Leon, who is currently running for the U.S. Senate, told Bloomberg News in January 2017: “California will continue to lead the world in addressing climate change and advancing clean energy regardless of who is in the White House or at the EPA. Mr. Pruitt should get used to that and not try to impose his Oklahoma views on the Golden State.”

We think CAFE will be in the headlines often in 2018 if the EPA lowers 2022-25 model year rules. We expect considerable legal resistance should the EPA say it is not proceeding with the original 54.5 mpg target. In a perfect world, we’d like to see no fuel economy rules, as we’d prefer to let the free market decide what an automaker’s fleet mileage should be. We suspect automakers feel the same way, though they’d never say so publicly for fear of negative publicity. However, given that large parts of the country do not want the Obama rules changed, we’d prefer to see the EPA leave the rules as is. A legal fight with many large states would only create uncertainty, which makes product planning difficult, and could drag on for years. Also, if California can continue to set its own rules, then its rules effectively become the national standard. The rules are strict but not impossible to meet, and at least the industry would have certainty.

Terminating NAFTA Hurts American Automakers The third major auto event from the White House started in the fall with the U.S., Canada, and Mexico meeting several times to discuss amending the North American Free Trade Agreement. The talks do not appear to be going well. The U.S. has not surprisingly taken an America First attitude and made proposals that have caused speculation that it is intentionally making unreasonable demands so that once the other parties reject them, Trump can justify exiting NAFTA and set up individual trade pacts with Canada and Mexico. It appears Trump dislikes multinational trade agreements in general. At the Asia-Pacific Economic Cooperation summit in Vietnam in November, he said, "What we will no longer do is enter into large agreements that will tie our hands, surrender our sovereignty, and make meaningful enforcement practically impossible."

We can understand why Canada and Mexico have balked at the U.S. proposal that the minimum vehicle content from NAFTA countries should rise to 85% from 62.5% presently, with at least 50% coming from the U.S., for a vehicle to have no tariffs. The U.S. also wants a so-called sunset clause in which the entire agreement would terminate in five years unless all three nations renegotiate the pact. In November during a fifth round of NAFTA talks in Mexico, the Mexican delegation proposed a structured review every five years instead of automatic termination. The Mexican proposal makes more sense to us, since a country can opt to exit anytime already. Canadian Minister of Foreign Affairs Chrystia Freeland also dislikes the sunset clause, telling reporters in November, after the fifth round of talks ended, that checking in every five years to end something is not “a good foundation for a lasting relationship.” She also particularly dislikes the U.S. automotive content demand. Canada’s lead negotiator, Steve Verheul, told members of the Canadian Parliament in December that U.S. auto demands are “wholly unworkable” and that any U.S. content requirement is unacceptable as it would put North America at a disadvantage to the rest of the world. U.S. Trade Representative Robert Lighthizer in a statement after the fifth round of talks said he believes Canada and Mexico are not seriously engaging on important areas of NAFTA and that “absent rebalancing, we will not a reach a satisfactory result.” The Trump administration is likely focusing on large automotive deficits and wants to see these reduced. According to the U.S. Commerce Department’s International Trade Administration, the 2016 U.S. goods trade deficits for autos with Canada and Mexico totaled $12.9 billion and $71.6 billion, respectively.

The countries have agreed to keep negotiating through March, at which point the Mexican presidential campaign begins, but it appears the countries are quite far apart, given the hardline U.S. demands. Small talks will continue, with the sixth full round of talks scheduled for the third week of January in Montreal. Other NAFTA observers see the U.S. tactics as dramatic rhetoric and that the deal will just be amended or Trump will give notice to withdraw but then not follow through after six months as the agreement’s exit provisions stipulate. Moody’s chief economist, Mark Zandi, said in an October

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interview, “It’s a lot of bluster. They’ll come up with a tweak and declare victory. At the end of the day Trump’s a businessman, and he’s got to be listening to businesspeople who are telling him it’s a bad idea to pull out of the deal.” We find Trump volatile and therefore unpredictable, but we hope Zandi is correct that the administration will ultimately realize protectionism is not a good idea for U.S. companies. We think the U.S. exiting NAFTA will only raise vehicle prices for American consumers and probably reduce annual auto sales, which in turn will reduce U.S. GDP growth and likely hurt American jobs. In late November, Vice President Mike Pence met with the CEOs of

Chicken Tax Is a Big Deal That Gets Little Attention Exiting NAFTA also makes the so-called chicken tax very important. Absent a new trade agreement, if the U.S. exits NAFTA, then World Trade Organization rules apply because Mexico and Canada joined the WTO in 1995, though the U.S. and Canada have a free trade agreement that would be back in place if NAFTA ended. WTO rules, amended by the chicken tax, mean a 2.5% tariff on cars imported into the U.S. from Mexico and a 25% tariff on imported pickup trucks and commercial vans. Our understanding is that the 25% tariff applies to trucks and commercial vans imported to the U.S. from any nation except Canada, since the U.S. and Canada had a free trade agreement in place before NAFTA. The 25% tariff on pickup trucks and commercial vans is the chicken tax, put in place to hurt Volkswagen's VLKAY/VLKPY Type 2 vehicle in early 1964 after France and West Germany imposed a tariff on U.S. chicken exports. The chicken tax helps protect the Detroit Three's 94% share of the U.S. full-size pickup market, but it will hurt some American automakers should the U.S. withdraw from NAFTA, given GM's and FCA's production base.

Exiting NAFTA is easy: Article 2205 of NAFTA simply states that a country can withdraw from the agreement six months after providing written notice to the other two countries. The other two countries can keep NAFTA terms ongoing between the two of them. The tricky part under U.S. law is whether the president can exit NAFTA without congressional approval. Under the Constitution, the Senate approves treaties, but NAFTA is not a treaty; rather, it is a congressional executive agreement that was put into law by House Resolution 3450. H.R. 3450 does not require the president to have congressional authorization to exit NAFTA, but neither does it state that he can unilaterally exit. The law may be on Trump’s side should he choose to exit NAFTA, but this action could be subject to lawsuits with the Supreme Court or fighting from even Republican members of Congress, which would cause more disorganization in Washington.

If Trump were to succeed in exiting NAFTA, then the question becomes whether he wants to punish Mexico with a 35% punitive tariff (instead of the 25% chicken tax) on its exports to the U.S., as he threatened in December 2016 before taking office, or whether he would instead allow WTO rules to apply. One reason we think free trade for autos should be preserved is that the 25% chicken tax would hurt GM and FCA, both of which make a fair number of pickups in Mexico. Both companies’ Mexican pickup production mix has increased slightly from 2016 levels despite Trump’s rhetoric. FCA’s heavy-duty pickup truck capacity is entirely in Mexico. These trucks are the most profitable vehicles the automakers sell, so Trump needs to be careful in weighing his decision to exit NAFTA if he wants to make American automakers “great again.” In the long term, we do not think GM or FCA will want to pay a 25% tariff (or more, in a punitive tariff scenario) on their most profitable vehicles, especially when Ford’s F-Series trucks are only made in America.

If automakers anticipated a 25% tariff or higher, we’d expect a production move for trucks to the U.S., which would require expensive retooling or possibly a new plant. GM has not said much on the tariff risk, but FCA is retooling its Warren, Michigan, plant to possibly handle heavy-duty pickup production in 2019 or 2020, though FCA hasn’t actually said production will move. If NAFTA dissolved and the chicken tax on pickups took hold, Toyota’s TM Tacoma pickup expansion in Mexico at its existing Tijuana plant as well as a new Tacoma plant in 2020 in the central Mexican state of Guanajuato would look foolish to us. Plans like this imply at least some players in the industry do not expect a radical change from current free trade policy with Mexico. In December, Toyota North America CEO Jim Lentz told Reuters, “I think the government will make the right decision. They will tweak, rather than throw out” existing NAFTA terms that allow tariff free trade. If Toyota is wrong, it is opening the door for GM to take more share in midsize pickups, since GM makes its models--the Chevrolet Colorado and the GMC Canyon--in Missouri.

VW and Nissan NSANY have significant Mexican exposure, but this production primarily comprises car models, so a 2.5% tariff would not be crushing to profitability, in our view. GM and FCA have both increased their Mexican mix from full-year 2016 levels of 18.7% and 18%, respectively, to about 23% and 28%, despite all the tariff talk and NAFTA uncertainty in 2017. Hyundai-Kia is also up from 2016 levels of 12.5% to about 23% due to new Mexican production of the Accent, Forte, and Rio. These companies perhaps are not concerned that NAFTA changes will be significant. In some cases, they are likely just willing to keep existing production and pay the 2.5% tariff on cars or are confident they can move production quickly, should major adverse tariffs on Mexican imports become a reality.

On the other border, Canadian-produced crossover models, such as the Toyota RAV4, Honda HMC CR-V, Chevrolet Equinox, GMC Terrain, Ford Edge, and FCA’s minivans, are not only popular but more profitable than compact cars imported from Mexico. Further complications come from parts that are made in Canada for vehicles built in the U.S. For example, Ford makes some of its pickup and Mustang engines in Canada, but then exports them to Kentucky and Michigan for final vehicle assembly. Tariffs on parts mean higher prices for consumers, which will drive down sales absent free trade. However, the Canada-United States Free Trade Agreement, which went into effect in 1989 but was superseded by NAFTA in 1994, would still mean tariff-free automobile importing between the two countries should the U.S. leave NAFTA, based on our talk with the Canadian government and provided that Trump imposes no punitive tariffs on Canada. If imports from Japan had a tariff beyond the 2.5% in place now for vehicles other than pickup trucks and commercial vans, Toyota would particularly suffer, as all the Lexus SUVs and all sedans, except some ES production in Kentucky and RX crossovers in Canada, are made in Japan.

Trump Has More Tariff Authority Than One Might Think Although the U.S. Constitution gives tariff authority to Congress rather than the president, there are laws that give this power back to the president under certain situations. History suggests these laws have wide interpretation for the president to act without congressional approval. In 1971, for example, President Richard Nixon, as part of his Nixon Shock moves that took the U.S. off the gold standard, invoked a 10% tariff on nearly all U.S. imports via the Trading with the Enemy Act of 1917. This law allows the president to restrict all forms of trade during war, even against a country the U.S. is not at war with. Nixon cited the Korean War, which technically never ended. Trump could cite things such as North Korea, the war on terror, and the use of American troops in the Middle East as justification to invoke the 1917 law. Another option is the 1977 International Emergency Economic Powers Act, which allows the president to use tariffs in response to a national emergency. The law lets the president act in response to threats to the economy. Trump could say that losing middle-class manufacturing jobs is a threat to the U.S. economy, something the people who voted for him in manufacturing states such as Michigan, Ohio, Pennsylvania, and Wisconsin would appreciate.

The Trade Act of 1974 could also be invoked. Section 122 permits 15% tariffs for up to 150 days, unless extended by Congress, to deal with “large and serious” U.S. balance of payments deficits if “fundamental international payments problems require special import measures to restrict imports.” The act does not define an international payment problem. Finally, the auto industry may be targeted by the Trade Expansion Act of 1962, Section 232 of which, per the Peterson Institute think tank, allows the president to levy tariffs if there is an “adverse impact on national security from imports.” We think tariffs this large only hurt American businesses and consumers, who will be forced to pay significantly more for a vehicle. Many consumers will simply avoid that vehicle and instead buy one without a tariff, or not buy a new vehicle at all.

In a January 2017 report, the Center for Automotive Research said that some vehicle parts cross a NAFTA border eight times before final assembly and that a 35% punitive tariff would eliminate at least nearly 40,000 American parts and assembly jobs. The multiplier effect of these job losses could equate to several hundred thousand job losses in sectors unrelated to autos. This report also estimated that U.S. auto sales would fall by 450,000 units and prices would rise. According to the U.S. Census Bureau, Mexico enjoyed a $64.4 billion trade surplus in goods with the U.S. in 2016 that was up more than 10% year over year through October. The same U.S. deficit with Canada was about $11 billion for full-year 2016. For 2017 through October, the deficit was about $14.3 billion compared with about $6.2 billion in the first ten months of 2016. The deficit with Canada increased significantly in 2017 due to the non-repeat of U.S. surpluses in March-June 2016.

We don’t envision a scenario where American consumers will be okay with Ford passing on to them a 35% punitive tariff on a Fusion midsize sedan currently made in Mexico when they can buy a Toyota Camry made in Kentucky, a Honda Accord made in Ohio, a Nissan Altima made in Mississippi, a Hyundai Sonata from Alabama, or a Kansas-built Chevrolet Malibu. Ford would have to either stop selling the Fusion in the U.S. or invest significantly to retool an American plant to bring back production. This would probably displace other investments for Ford’s future. Even if the tariff is just the WTO rules’ 2.5% rate on cars, the Fusion is at a disadvantage to the other midsize sedans, but a tariff that small probably does not give Ford an incentive to incur the extra costs to move sedan production to the U.S. Ford may stop selling the Fusion in 2020 in the U.S. anyway, as it has reportedly told suppliers that the next-generation Fusion will not be built in Mexico. The vehicle’s future is unclear at this time. Our view is that no country wins in a trade war and that the U.S. would be hurting its own economy with protectionist tariffs. The U.S. went down a protectionist trade path in 1930 with the passage of Smoot-Hawley, which caused all U.S. imports to fall about 40% in slightly over two years and helped set the stage for a painful decade of economic growth and eventually World War II.

Mexican Political Change Coming The Trump administration's policies will ultimately increase or decrease unemployment and consumer confidence, which will move auto sales. The big uncertainty is to what degree Trump's policies will affect auto demand, and we think the fate of NAFTA is the most significant factor in answering that question. We want the three countries' trade representatives to have a breakthrough as soon as possible. If the U.S. does not change its stance, then a U.S. exit is not a low-probability event, in our opinion. Time is running out because Mexico will have a new president after its election July 1. Current president Enrique Peña Nieto is at a term limit. Andrés Manuel López Obrador, a populist who is basically the Trump of Mexico, is favored. We doubt Obrador and Trump will get along, as Obrador has championed the human rights cause of Mexican migrant workers in the U.S. and in 2017 criticized Trump's campaign of hatred, according to Bloomberg News. Obrador claims to support free trade but wants to deal with amending NAFTA after the election and does not favor inserting tariffs into the current NAFTA agreement. His embrace of free trade does not sound totally accurate to us, though, because Obrador has said he will repeal a 2013 law that opened Mexico to foreign energy investments. If NAFTA is amended before the election and Obrador does not like a new deal, then that brings more uncertainty to the fate of auto tariffs in North America. It's possible that Obrador as president would not want to exert the effort to once again amend NAFTA, given that Canada and the U.S. would in our view not be eager to have more talks so soon after already changing the deal before the election. The other possibility is that an agreement is not reached before the election; then Mexico could take a harder line with the U.S. than even now and the U.S. could decide exiting NAFTA is best.

The average Mexican voter may have reason to vote for Obrador. The Gini coefficient measure of income distribution within a country, with 1 representing perfect inequality and 0 perfect equality, is not favorable for Mexico. Mexico actually has the most inequality of any of the 35 OECD nations at 0.46. The U.S. figure is 0.39, Canada’s is 0.31, and the OECD average is 0.32. According to the Council on Foreign Relations, Mexican poverty is at the same levels as it was in 1994 when NAFTA took hold, and Mexico’s economic growth rate and per capita income growth rate have lagged those of other major Latin American economies. Mexican unemployment, according to St. Louis Federal Reserve data, is about the same it was in 1994 at 3.5% recently and has trended downward since its last peak of 6.1% in 2009. Most of these facts suggest the populist uprising that hit the 2016 U.S. presidential elections will repeat itself in Mexico in 2018, but this time such an uprising won’t be a surprise.

The uncertainty around auto tariffs for Mexican imports into the U.S. places FCA, GM, and Toyota at risk due to their Mexican pickup production exposure. Should Trump levy a punitive tariff on Mexican imports, we do not see how Americans will be willing to pay at least a 25% tariff on pickup trucks. We think the three automakers would have to bring this production to the U.S. or Canada to avoid the chicken tax or keep Mexican production and then offset some of the 25% tariff’s harm via moving some of the parts production to Southeast Asia or China. We think Toyota would be the most likely to try the Asia approach, given its Japan base, but whoever tries it is taking a risk, in our view, that American pickup customers will accept models with Chinese or Southeast Asian content. Toyota makes its full-size truck, Tundra, in Texas to minimize foreign exchange risk but also for marketing purposes--to make the truck seem as American as possible. This strategy has not worked well, however, as pickup buyers remain fiercely loyal to the Detroit Three. American automakers have 94% of the full-size pickup market, with the Tundra never having more than 8.9% segment share. Toyota does well in midsize trucks, however, with the Tacoma the leader in 2017 holding 44% share versus 32% at GM, the only American company for now in the segment (Ford will bring the Ranger back and make it in Michigan in late 2018). The full-size truck segment is over 5 times larger than the midsize at about 2.4 million full-size trucks sold in 2017.