Tariff escalation fuels Canada’s recession risk, strains outlook

Canada's economy was already under strain before the latest round of US tariffs landed.

Now, with escalation threats mounting and a potential doubling of levies on key sectors looming for January 2027, the pressure on plan sponsors and institutional investors to cut through the noise has sharpened.

BeiChen Lin, head of Canadian investment strategy at Russell Investments, said the Section 338 tariffs - applied at 50 per cent on a subset of Canadian goods - touch only about 5 per cent of Canada's exports to the US. But Lin underscored how context matters here, noting that the Section 338 tariffs are just piling onto an already difficult situation rather than creating a new one.

Tariff pressure hits an already strained economy

“The unfortunate news is that Canada's economy is already under pressure,” said Lin. “The Q2 GDP numbers were really robust, but that does not change the fact that Canada is still operating at what economists call a negative output gap. In other words, if you look at where Canada's economy is operating today versus where it should be based on long-term potential, we are at a gap of about, roughly 1 to 2 per cent. So Canada's economy is running below the longer-term potential.”

The deeper risk, Lin suggests, is what escalation does to confidence. Lin argued that businesses facing uncertain tariff timelines tend to freeze, like shelving expansion plans, pulling back on hiring, and conserving cash.

Growth drag is biggest risk for investors

To that end, he emphasized that tariffs aren’t primarily an inflation story, but that growth drag is the bigger risk. He underscored that the balance between the two comes down to the state of the consumer. Canadian households are carrying elevated debt loads and facing an unemployment rate already above the long-term average - conditions that limit how much of the tariff cost businesses can pass through.

"I think you're most likely looking at a scenario where they can’t push 100 per cent of the tariff costs through to consumers because consumers won't be able to absorb it," he said.

Russell expects that dynamic to keep hiring activity and business investment depressed through at least year-end. While the firm currently pegs Canada's recession probability at 35 per cent for the year ahead, down from 45 per cent after stronger GDP data, “if we continue to see further trade escalations, then that recession probability for Canada might go back up again,” said Lin.

By contrast, Russell pegs US recession risk at just 15 per cent.

Where Bank of Canada stands on tariffs

That asymmetry also feeds into the Bank of Canada's calculus. Lin agreed that the central bank faces a difficult balancing act but said growth concerns should dominate.

“Core inflation for Canada is running pretty close to that 2 per cent target,” he said, adding that the official target band of 1 to 3 per cent gives the Bank of Canada room to manoeuvre. He expects the Bank to hold rates at its upcoming meeting but sees a cut coming later this year.

"Where the market is toying with the idea of a potential rate hike by the end of this year and looking at even more rate hikes into 2027, I just think that the market forecast is too aggressive, too hawkish," he said.

According to Lin, the Bank of Canada has identified two primary risks on its radar: the Middle East conflict, which it views mainly as an inflationary threat, and the Canada-US trade war, which it sees as a drag on growth. In his view, the Bank will prioritize supporting economic activity over guarding against modest inflation pressures, making a rate cut before year-end a strong possibility.

"We're seeing some really good value in the short end of the curve at the 2-year point for the BoC, because ultimately that 2-year point is going to be the most sensitive to the short-term rate pricing," Lin said. “It's quite likely that because of this elevated trade uncertainty, we're going to see hiring activity and business investment remain depressed for at least through the end of 2026. And ultimately, that will dampen the prospects of economic growth in Canada.” 

Why retaliatory tariffs won’t impact America

Still, Lin argued it would take far more than the current tariffs to put a real dent in US growth as the American economy is starting from a position of resilience, giving it a larger buffer against downside shocks.

Trade flows also work in the US' favour and Canada is far more dependent on exports heading south than the US is on exports heading north, which means Canada's retaliatory tariffs won't hit American exporters in any significant way. The Section 338 tariffs, covering just 5 per cent of imports from Canada, are similarly modest in their impact on US output.

The one scenario where Lin sees a more noticeable drag on American growth is a doubling of auto and sectoral tariffs on January 1, 2027. The deep supply-chain integration among Canada, the US, and Mexico in sectors like automobiles means disruption would ripple across borders.

“But even in that scenario, we continue to think that the growth impact is going to be asymmetric, where the growth burden is going to be felt more sharply in Canada than south of the border,” said Lin.

Investors should stay the course

For investors watching tariff headlines whipsaw markets, Lin suggests maintaining discipline over reactivity. He compared the environment to Liberation Day last year, when sentiment swung from escalation to de-escalation within days.

"Not every news development warrants a tweak to their portfolio," he said. "There's times when investors would benefit from making tactical tilts, but there's also going to be times where even when it's raining hard outside, it shouldn't change their schedule for the day, so to speak," he said.

One area where Lin does see investors falling into a trap is surface-level analysis of Canadian equities, noting the composition of Canada's equity market diverges from the composition of its economy and that the TSX, buoyed by a strong financial sector, could continue to perform even as growth sputters.

"If you were to take a deep dive under the hood and you look at what's the composition of the equity market versus what's the composition of the economy, then you'll start to see that the impact might not be necessarily what you think it is at first blush," he said.