Middle East flares up

Israel launched an attack on Iran on June 13 that targeted missile sites, senior military staff, nuclear facilities, key nuclear scientists and some oil facilities. Iran’s military and nuclear capabilities are thought to be significantly degraded, though its most important nuclear development site is still potentially operational.

Iran has since responded with its own drones and missiles. Most were halted by Israel’s Iron Dome, but some reached their targets. The back and forth continues and is expected to last for days.

Several factors seemingly motivated the Israeli attack:

• The two countries are long-time enemies: Iran has for decades funded military efforts against Israel via a number of regional proxies, and the two countries struck one another directly in 2024.

• Iran was weakened by Israel’s earlier successful actions against the country’s proxies and against Iran itself, rendering Iran vulnerable to a decisive attack such as the one now underway.

• The Iranian regime is unpopular at home, and Israel may hope that this war provides a sufficiently large shock that results in regime change.

• The world has long been concerned that Iran is on the cusp of developing nuclear weapons. The International Atomic Energy Agency declared last week that Iran is now in violation of its safeguard agreements for the first time in almost two decades. Israel’s attack is at least partially directed at stopping Iran from realizing its goal.

• Israel may have been concerned that the U.S. was about to strike a deal with Iran that would not actually prevent Iran from continuing to develop nuclear weapons.

From an economic standpoint, the main implication of this new conflict is higher oil prices (see next chart). The price of a barrel of Western Texas Intermediate (WTI) oil has risen from US$61 at the end of May to US$72 today.

Crude oil prices have risen in the wake of the new Israel-Iran conflict

As of 06/13/2025. Sources: Macrobond, RBC GAM

Higher oil prices bring the usual set of pro-inflation and anti-growth properties, a bit like tariffs. A key difference is that oil prices fell by a similar margin between early April and late May, such that we can still say oil prices are net disinflationary across the entirety of 2025, and still slightly supportive of global growth. But the shift does eat away at the prior positive narrative.

Other consequences include a higher chance of regime change in Iran, greater overall geopolitical uncertainty, and another development that fits into the narrative that the world is a more dangerous place than it once was as the global order transforms.

Risks extend in both directions. It’s entirely possible that the conflict ebbs and oil prices accordingly retreat back into the $60s. But if the war were to broaden across the Middle East, or Iran were to shut down the Strait of Hormuz, the oil price increase could be vastly greater.

Economic fears are fading . . . but economic data now weakening

As tariffs fail to track their worst-case trajectory and as the initial economic damage proves surprisingly slight, previously dour forecasts and pessimistic sentiment has been rebounding somewhat.

The consensus 2025 gross economic product (GDP) growth outlook for each of the U.S., European Union (EU), UK and Canada all increased somewhat over the past month, though they do still brace for tariff damage.

Measures of business sentiment are also rebounding. The small business confidence metric from the National Federation of Independent Business (NFIB) is up notably and the CEO Confidence Index is now beginning to creep higher after an earlier large drop.

Consumer confidence is also rising, with traditional survey-based metrics cautious but up slightly, and one social-media based measure up sharply to outright optimistic levels (see next chart).

U.S. consumer sentiment revived on Trump tariff pause

GS Social Media Economic Sentiment Index as of 05/30/2025, University of Michigan Index as of June 2025, Conference Board Index as of May 2025. Sources: Goldman Sachs Global Investment Research, University of Michigan, The Conference Board, Macrobond, RBC GAM

…but economic data now genuinely weakening

However, after many months of defiantly normal economic growth in the U.S. and a second-quarter GDP print that is presently tracking a big +4% annualized (albeit representing an artificial “bounce back” after a prior weak quarter), we are now starting to see hints of economic weakness ahead.

U.S. payrolls in May weren’t quite as normal as they first looked when downward revisions are factored in.

Our U.S. Focused Economic Surprise Index has tilted in a negative direction, with five of seven inputs recently disappointing (see next chart). That includes the Institute for Supply Management (ISM) Manufacturing and ISM Services indices, both of which are now at levels consistent with mild economic contraction.

U.S. Focused Economic Surprise Index deteriorates

As of 06/13/2025. U.S. Focused Economic Surprise Index (FESI) is the equal-weighted average of the normalized data surprises of the underlying components. Sources: Bloomberg, RBC GAM

The Citi Data Change Index for the U.S. has absolutely collapsed in recent weeks. This reflects in part some genuine economic softness (see next chart), though it also constitutes an overreaction to volatile durable goods orders and lower imports. Directionally, the index is likely correct, but the new level probably overstates recent weakness.

U.S. economic data have been deteriorating since Trump inauguration

As of 06/16/2025. Sources: Citigroup, Bloomberg, RBC GAM

Real-time indicators such as weekly jobless claims (see next chart) and the Dallas Fed’s Weekly Economic Indicator (see subsequent chart) are also now deteriorating.

U.S. jobless claims creeping higher slowly

As of the week ending 06/07/2025. Sources: U.S. Department of Labor, Macrobond, RBC GAM

Federal Reserve Bank of Dallas Weekly Economic Index also deteriorating

For the week ended 05/31/2025. The Weekly Economic Index (WEI) is an index of 10 indicators of real economic activity, scaled to align with the four-quarter GPD growth rate. Sources: Federal Reserve Bank of Dallas, Macrobond, RBC GAM

The Fed’s latest Beige Book also says that “Half of all Districts reported slight to moderate declines in activity”, which was certainly weaker than the prior assessment (see next chart). All Districts reported lower labour demand.

Beige Book Sentiment Indicator shows declining activity

As of May 2025. The indicator quantifies the sentiment of local contacts by assigning different weights to a spectrum of positive and negative words used to describe overall economic conditions in the U.S. Federal Reserve (the Fed) Being Book. Sources: U.S. Federal Reserve, RBC GAM

U.S. CPI also plays waiting game

U.S. inflation is also taking its time capturing tariff effects. May’s Consumer Price Index (CPI) was quite soft at the aggregate level, with a mere 0.1% increase for both total CPI and core CPI. That constituted a fourth-consecutive month in which core inflation was below the consensus.

Theoretically tariff-linked components such as apparel costs and (ex-fuel) transportation costs were actually down on the month (see next chart), and furniture prices were soft. On the other hand, appliance and audio-video product prices were higher.

U.S. monthly inflation rate by category

As of May 2025. Sources: U.S. Bureau of Labor Statistics (BLS), Macrobond, RBC GAM

But we continue to anticipate some increase in U.S. inflation ahead given evidence in the real-time price data that China-sensitive sectors such as apparel, furnishings and recreation & electronics are starting to accelerate in a manner not seen in several years (see next chart). Critically, U.S. aggregate inflation might rise to something like 3.5%. This is an elevated level, but nothing like the peaks achieved in 2021 through 2023.

U.S. Daily PriceStats Inflation Index shows rising inflation

As of 06/08/2025. Sources: State Street Global Markets Research, RBC GAM

Federal Reserve decision is coming

The U.S. Federal Reserve has become somewhat less hawkish in its comments over the last several months but remains unlikely to deliver a rate cut at its meeting this week. While there are hints of economic softness approaching, the evidence remains mild and only tentative. Meanwhile, although inflation has also not yet reared its head, there are hints it could pick up in the coming months.

Absent a clear trend in either variable and with no economic slack visible in the economy, the Fed isn’t in a rush. Given the fickle nature of tariff policy decisions, it is impractical to deliver monetary policy on the basis of where tariffs might go, keeping the central bank in reactive mode.

This isn’t to say that the Fed will be entirely idle. It will update its dot-plot forecasts last generated way back in March, with a likely cut to the U.S. 2025 GDP forecast and a moderate increase to the 2025 inflation forecast given the tariff trajectory since then. The Federal Open Market Committee (FOMC) will also presumably price in a bit more rate cutting for the year ahead. Financial markets currently assume two 25 basis point rate cuts this year and another two next year. 

Tariff developments continue

The flow of tariff developments is no longer quite as frenetic as it was in March and April, but there continue to be substantial developments nevertheless. The direction of travel is mixed, with higher steel and aluminum tariffs pitted against another mini trade deal between the U.S. and China, and rumours of progress in trade talks on a number of fronts.

The bad tariff news

The primary bad news is that global steel and aluminum tariffs doubled on June 5, from 25% to 50%.

Why? President Trump said that foreign producers were still viable at 25%, necessitating a further increase to sufficiently advantage domestic production. A second subtler reason may be that as legal challenges threaten the White House’s ability to implement tariffs that target an entire nation, sector-oriented tariffs remain legally viable and so are being leaned on more heavily.

The steel and aluminum tariff hike is particularly problematic for the countries with the largest such exports to the U.S., including Canada, Mexico, Brazil and South Korea (see next chart). The overall average U.S. tariff rate has accordingly increased on Canada from 4.1% to 5.8%, on Mexico from 12.3% to 13.9%, on Brazil from 9.9% to 12.0%, and on South Korea from 13.6% to 15.3%. The tariff rate on China rises from 39.3% to 40.7%.

Canada, Mexico are largest exporters of steel and aluminum to U.S.

Sources: U.S. Census Bureau, Macrobond, RBC GAM

This decision continues to highlight the variability of U.S. tariffs. Even after a sector or country has been targeted, there is still every possibility that the assigned tariff rate will later be reduced (as per reciprocal tariff delays) or increased (as per these new steel and aluminum tariffs).

As a result of this latest action, the average U.S. tariff rate rises from 13.5% to 14.7% (see next chart).

Average U.S. tariff rate is rising

Effective tariff rates estimated based on tariffs implemented by the Trump administration up to June 4, 2025. Excludes de minimis effect. Sources: Evercore ISI Tariff Tracker, International Monetary Fund (IMF), Macrobond, RBC GAM

As it happens, that is around where we are assuming the average rate eventually settles, though with some offsetting tweaks. We expect further sector-oriented tariffs (potentially on copper, forestry, pharmaceuticals, computer chips and critical minerals), and think that some countries with especially large trade surpluses could see their tariff rates rise above the current baseline 10% (such as Vietnam, South Korea and Taiwan). On the other hand, we presume that a significant number of countries will manage to strike deals with the U.S. that result in country-specific curated tariff exemptions. The net result, we think, is an overall tariff rate that approximates the 15% currently in place.

A further adverse development is that, on June 10, the Federal Circuit court extended the legal stay that had been issued by a lower court in late May, with the implication that existing tariffs based on the International Emergency Economic Powers Act – prominently, that includes reciprocal tariffs – will remain in force through the late summer. It appears that the administration can also level further such tariffs during this period of time. We discussed the legal situation in more detail in the last MacroMemo. The main takeaway is that there is enough other tariff-enabling legislation available that the White House should be able to achieve its objectives over the medium run. But such legal questions do reduce the weight of U.S. tariff threats in the short run.

The good tariff news

The main good news on the tariff front is that the U.S. and China have apparently managed to work through some of the kinks in their prior de-escalation agreement. China will reportedly provide access to its rare earth elements more readily, and Chinese students will not be blocked from receiving American student visas. It is less clear whether the U.S. is reversing its recent tightening of restrictions against Huawei or easing restrictions on the export of certain key U.S. products to China. There had been talk of such moves from the U.S. contingent going into the negotiations. For its part, China appears to be downplaying the significance of the deal.

Still, even with a small détente, the U.S. continues to impose large 30%-plus tariffs on China, and the flow of goods from China to the U.S. has deteriorated sharply in recent months (see next chart).

Chinese exports to U.S. plummet

As of April 2025. Monthly series, sa.X-11 ARIMA, rebase 03/21=100. Sources: China General Administration of Customs (GAC), Macrobond, RBC GAM

We continue to believe China has the stronger bargaining position of the two countries. China is managing to pivot some of its exports toward other markets. It is also not as reliant on the U.S. as the U.S. is on China in terms of trade as a share of GDP. China also sells more differentiated products to the U.S. than the reverse, making it harder for the U.S. to find substitutes for these products.

Foremost among these differentiated products are China’s world-dominating supply of rare earths. These have attractive magnetic and heat-resistant properties, rendering them critical for sophisticated electronic equipment. China mines 70% of the world’s supply and processes an even larger 90% of it. In early June, major U.S. automakers were fretting that they would have to shut down some of their car production if they could not secure additional rare earth magnets. This no doubt prompted redoubled U.S. negotiating efforts.

Active negotiations

With the July 9 reciprocal tariff deadline fast approaching, the White House has been attempting to increase its pressure on other countries. It issued an early-June deadline – now passed – for countries to propose their best offers to the U.S. It is unclear which countries complied or whether the demand was taken seriously.

There is a strong argument that countries should drag their feet, as the U.S. bargaining position is weakening. The U.S. probably doesn’t want to actually follow through on its threat to raise tariffs on July 9 on a large number of major trading partners, as that will be quite painful to the U.S. economy. The fewer deals the U.S. has struck by that date, the less likely it is to allow the higher rates to revert.

Indeed, Treasury Secretary Bessent recently told the House of Representatives that the July 9 deadline may be extended for countries negotiating in good faith. The legal status of tariffs is also getting murkier, reducing the credibility of U.S. threats if deals are not struck. Finally, if the UK trade deal constitutes what countries can expect to get out of a deal – meaning that they will continue to have to pay the 10% baseline tariff rate on most products, absent a few exemptions – then the urgency to strike a deal that isn’t much better than their present arrangement is low.

Importantly, Canada is apparently fairly far along in negotiations with the U.S. The Prime Minister’s Office has just announced that while a deal was not struck at the G7 summit in Kananaskis, it hopes to strike a deal within the coming 30 days.

For its part, the UK may have been in more of a hurry than other countries to pen a deal because it is seeking to re-establish itself on the global stage post-Brexit. To that effect, it also penned deals with India and the European Union in recent weeks.

Fragments of other negotiations are trickling out.

Importantly, Canada is apparently fairly far along in negotiations with the U.S. The Prime Minister’s Office has just announced that while a deal was not struck at the G7 summit in Kananaskis, it hopes to strike a deal within the coming 30 days. Subjects broached apparently include critical minerals, border security and the potential for cooperation on defense. Further topics that have been mentioned in reports of the negotiations in recent weeks include Canada investing in Arctic infrastructure, increasing military spending, making additional military purchases from the U.S. and potentially committing to missile defense integration via the proposed Golden Dome. Details are non-existent on what precisely Canada might gain in reduced tariffs.

There are also rumours of a U.S.-Mexico steel deal being negotiated. A quota system is apparently being discussed in which a set volume of steel would be exempted from tariffs, akin to the UK framework.

Exchange rate concessions?

As negotiations continue, one of the less conventional items that may be on the agenda is the valuation of the U.S. dollar. Even after its recent decline, the greenback is quite expensive (see next chart).

U.S. dollar depreciates on Trump tariff turmoil

As of May 2025. Shaded area represents U.S. recession. Sources: Federal Reserve, Macrobond, RBC GAM

What is more, the White House wants the currency softer, as this will render U.S. exports more competitive and conceivably shrink the size of the country’s trade deficit. A depreciation would also import more inflation, but that’s another story. Many countries would probably not be averse to some depreciation in the dollar, as their own currencies are unusually weak. But again, this brings with it competitive advantages but also disadvantages such as additional inflation and more expensive imports.

Practically speaking, global currency and financial flows are so large that it would be difficult for official reserve managers with their relatively limited resources – even though those resources can run into the hundreds of billions of dollars – to substantially and enduringly shift currency valuations away from their equilibrium. Instead, you would likely see a joint statement pledging to return exchange rates toward their fair value, with the respective countries’ central banks ceasing activities that run counter to that foreign exchange move – and countries counting on market forces to do most of the rest.

Other countries might prefer this sort of concession to the U.S. over something like explicit purchasing commitments, as it is difficult within the context of a large, complicated economy to coordinate the large-scale purchase of particular goods from a particular country. Further, the commitment to assist in devaluing the U.S. dollar requires less action and is easier to sandbag or even abandon at a later date when the White House has a different occupant.

U.S. tariffs vs Brexit

Some estimates put the effect of Brexit – the UK decision to erect barriers by exiting the European Union – at the equivalent of a 10-20% tariff on the EU. That’s interesting, as the current U.S. tariff rate is a similar 15%.

The parallels between U.S. tariffs and Brexit are clear, though it must be conceded that it is an imperfect comparison:

• The UK did not actually encounter tariffs that high, but rather suffered consequences equivalent to such tariffs via greater non-tariff border frictions such as increased paperwork.

• The 10-20% rate for the UK is just for goods trade versus the EU, as opposed to the average against all trading partners (though the UK did lose access to pre-existing EU trade accords with third parties).

• The UK was also altering its regulatory and immigration regimes at the same time (though the U.S. is also making similar changes to its immigration rules, as it happens).

With those limitations in mind, what was the Brexit economic impact? A recent study from Stanford University finds that GDP ultimately suffered a 6-9% decline relative to its counterfactual trajectory. Productivity was 3% lower than otherwise, and business investment was an enormous 12-20% lower. The point is that we have modern precedent for the sudden erection of trade barriers, and the economic damage was considerable. As such, we shouldn’t back away too quickly from models arguing for substantial economic damage, even if that damage is taking its time to arrive.

Another ex-U.S. tariff inflation downgrade

In a late April MacroMemo, we discussed how the inflation boost from tariffs for non-U.S. countries should be more limited than previously imagined. As we noted at the time:

• Other countries simply aren’t retaliating very much to U.S. tariffs (which limits the domestic inflation impact).

• There may be a deflationary influence from the dumping of surplus products.

• The economic weakness associated with tariffs also imposes its own disinflationary impulse.

This is all still true, but we now flag a further supportive argument to consider.

A non-trivial fraction of the remaining inflation increase that usually appears in the countries being targeted by tariffs comes from a weaker exchange rate. Theoretically, countries imposing tariffs should see their exchange rate strengthen, and those being hit by the tariffs should experience a currency deprecation. That, in turn, creates some amount of additional inflation in the targeted countries.

But that isn’t happening this time. The U.S. dollar is down, and other currencies are up. As such, this constitutes a fourth way the usual inflation impulse isn’t arriving outside of the U.S.

As such, we have again downgraded our ex-U.S. assumed inflation impacts, with global ex-U.S. inflation now expected to rise by a mere +0.2% (versus +0.6% previously). The effect is somewhat larger in China and Canada. This is in part because these economies are simply more affected by tariffs, but in large part because they happen to be among a small number of countries actually retaliating against the U.S. However, as we will discuss later, Canada’s response is smaller than it looks.

Tariff scenarios

As at 06/12/2025. All figures are the expected ppt change to the trajectory of GDP, CPI or the unemployment rate. The tariff rate for the U.S. is the trade-weighted average tariff it applies on others. For other countries and global, the rate is the average tariff applied by the U.S. on that country. A 0% tariff still induces economic damage due to high uncertainty and boycotts. The estimates presume a less than 1-for-1 response by the targeted countries. Source: RBC GAM

Why are the inflation numbers still positive if so many traditional inflationary drivers have failed to materialize? This is because there are still a few other potential inflationary channels that linger:

We still budget for the possibility that some countries increase their tariff retaliation later, as the EU is threatening to do.

Supply chains become gnarled on both sides of the border when tariffs are implemented leading to bottlenecks that increase prices.

Some intermediate products cross the border multiple times, such that even countries without tariffs of their own may wind up paying for part of another country’s tariffs.

To the extent tariffs gum up the global economy’s efficiency, productivity falls. This in turn may result in companies raising prices to defend their profit margins.

Tricky tariff math

If it seems as though there are competing estimates for what the average U.S. tariff rate is on its trading partners, you’re entirely correct. All sorts of different numbers are circulating.

Part of the challenge is of course that tariff rates are ebbing and flowing with amazing frequency, not to mention that not all tariff threats are ultimately acted upon.

A more fundamental issue is in how the math itself is handled. We have generally looked at the trade flows that were in place before the tariffs arrived and then applied the active tariff rate to these. But this may overstate the realized tariff rate because products with large tariffs usually see a drop in demand relative to products without tariffs, such that the actual average tariff rate is lower.

To use an extreme example, does a country facing a 1000% tariff on half of its exports have a 500% average tariff rate, or instead a 0% tariff rate if all of the tariffed exports dry up because they are uncompetitive? In practice, no tariff revenue is being collected, but on the other hand there is still a large economic barrier in place that reduces the productivity of both nations and increases prices in the nation applying the tariff. We prefer the first number to the second, but neither is perfect.

Another challenge is that some of the tariff math is simply impenetrable.  As an example, given that only the value-added portion of auto imports is tariffed by the U.S. on products coming from Canada and Mexico, it is not possible for an outsider to calculate in advance the exact amount that will be tariffed.

There is also the question of exporters working around tariffs by subtly altering products – such as by applying some trivial adjustment to a raw material to convert it to a “manufactured” product that is then subject to a lower tariff.

Similarly, there have been anecdotes of customs officials not having the capacity or knowing how to apply the many new tariffs now in place, with the effect that tariffs may be applied inconsistently, and with a lower effective average rate than theory would argue.

A new front opens in trade war

Trump’s trade war has substantially increased tariffs on the United States’ $3.3T in annual goods imports. Now the administration appears to be opening a new front, threatening to increase taxes on a portion of the $1.4T in annual income earned from foreign investment in the U.S.

Buried in the House budget bill passed in May – which is now being revised in the Senate – Section 899 proposes retaliatory taxes on investment in the U.S. by foreign corporations, individuals, private foundations, trusts, governments, and government-related entities from “discriminatory foreign countries.”

Those are countries that have enacted aspects of the global minimum tax framework from the Organisation for Economic Co-operation and Development (OECD) which the U.S. deems unfair. Digital services taxes (DSTs), undertaxed profits rules (UTPRs), and less-common diverted profits taxes (DPTs) are specifically called out.

Note that the broader tax bill has yet to be signed into law. Section 899 and other elements could be altered or dropped in the final version, which is expected to reach the president’s desk sometime this summer. But policy experts suggest some form of Section 899 is likely to be implemented. And the House version would have a broad impact on foreign investors.

Some 30 countries have implemented or announced a UTPR. A similar number have some form of DST, though there’s overlap between the two groups – we count about 40 in total. Canada, the UK, most EU countries, and several large Asia-Pacific economies could all be labeled “discriminatory.” The table below shows the top foreign investors in the U.S. that have at least one “unfair” foreign tax.

Many countries have at least one “unfair” foreign tax

As of 06/11/2025. Sources: U.S. Bureau of Economic Analysis, PricewaterhouseCoopers, Tax Foundation, RBC GAM

While Trump has expressed displeasure with other countries’ value added taxes (VAT), Section 899 specifically excludes VAT and sales tax from the definition of extraterritorial or discriminatory taxes. But again, the Treasury Secretary has some discretion in that regard.

Realistically, Section 899 should be viewed as more of a negotiating tool than a revenue generator. Its main objective appears to be pressuring countries to abandon taxes that are seen as discriminating against or falling disproportionately on U.S. multinational enterprises (MNEs).

It applies pressure by increasing taxes on foreign MNEs operating in the U.S., as well as certain types of portfolio investment in the U.S. by foreigners.

Governments and some government-related entities – including pension funds and sovereign wealth funds, but not central banks – that were previously exempt from withholding taxes could now be subject to levies. Registered accounts could also be taxed under Section 899.

Foreign MNEs with subsidiaries or branches in the U.S. could face higher withholding taxes on dividends repatriated to foreign parent companies, higher corporate taxes on branch company profits, and additional taxes on certain inter-company transactions.

Foreign portfolio investment – like purchases of U.S. equities by individual investors – will also face higher withholding taxes on dividends. Conversely, portfolio interest payments – most notably Treasury coupons – are expected to remain exempt. Interest payments on direct lending might be in scope, which could impact foreign banks operating in the U.S.

Section 899 would increase withholding taxes on dividends by 5 percentage points per year starting in 2027 (the House had proposed 2026 but the Senate has countered with 2027). The increase would apply from the current statutory (30%) or treaty (in many cases lower) rates to a maximum of 20 percentage points above the statutory rate.

Governments and some government-related entities – including pension funds and sovereign wealth funds, but not central banks – that were previously exempt from withholding taxes could now be subject to levies. Registered accounts could also be taxed under Section 899.

Countries with DSTs and UTPRs are only taxing a subset of U.S. MNEs operating abroad, while the U.S. threatens sweeping taxes with Section 899. The administration is hoping other countries will back down, but there appears to be scope for escalation as well.

Taxing MNEs operating in the U.S. discourages foreign direct investments (FDI), arguably working against the Trump administration’s objective of boosting domestic investment and production. Foreign companies seeking to avoid U.S. import tariffs by setting up shop in the U.S. face the prospect of higher taxes on repatriated profits.

Most of the top source countries of FDI into the U.S. have some form of discriminatory tax. By our count, potentially discriminatory countries account for 86% of FDI in the U.S.

The U.S. economy relies on that investment. U.S. affiliates of foreign MNEs accounted for 6% of private jobs in the U.S. as of 2022 and nearly 7% of business-sector GDP. They were responsible for even greater shares of business capex and R&D (around 16% and 12%, respectively).

The manufacturing sector is particularly dependent on foreign MNEs. They account for 22% of employment in the industry and 20% of value added. New investment by foreign MNEs created 25k factory jobs in 2023 with another 20k planned by project completion. That activity could be jeopardized by Section 899.

While a higher withholding tax on dividends will slightly erode expected returns and might discourage some investment flows, we wouldn’t expect a mass exodus from U.S. equities. Capital gains don’t appear to be touched by the House version of Section 899.

From a portfolio investment standpoint, foreigners also hold about 50% more U.S. equities than U.S. investors hold foreign equities. The U.S. equity market has consistently outperformed major foreign indices and offers investors unique exposure to some of the world’s most dynamic and innovative companies.

In fairness, investors in U.S. equities aren’t necessarily seeking dividends. Only 15% of the S&P 500’s 102% return over the past five years came from dividends. The index’s 1.3% dividend yield is well below that of most other countries’ equity indices.

While a higher withholding tax on those dividends will slightly erode expected returns and might discourage some investment flows, we wouldn’t expect a mass exodus from U.S. equities. Capital gains don’t appear to be touched by the House version of Section 899.

Overall, Section 899 could add fuel to the Sell America theme as the Trump administration continues to rewrite the rules of trade, security and now investment. If countries can’t be coerced into dropping their global minimum tax measures and withholding taxes ramp up in the coming years, we would expect less investment in the U.S. and less demand for U.S. dollars.

For our part, we think it is most likely that other countries manage to negotiate away this threat, either by retreating from their own global minimum taxes and digital services taxes, or as part of a broader trade deal with the U.S. It is notable that the Senate is already seeking to push back the implementation date by a year, reflecting a lack of enthusiasm for the taxes to be implemented, even in the U.S. But the risk of a significant reduction in the after-tax return on foreign investments into the U.S. cannot be entirely discounted.

Implications for Canada

Canada is likely to land on the list of discriminatory foreign countries for its digital services tax. Indeed, Canada has been called out explicitly by the White House.

In Canada’s case, dividends paid to a parent company are generally taxed at a 5% treaty rate and payments to individual investors at 15%. Both could rise to as high as 50% over time, and it appears those higher rates would not be deductible from Canadian tax liabilities.

The central issue is that Canada passed its Digital Services Tax Act in June 2024, which levies a 3% tax on Canadian digital services revenue in excess of C$20 million.

Could Canada also be implicated for its June 2024 Global Minimum Tax Act (GMTA)? Probably not, because the country has not yet incorporated an undertaxed profit rule as part of that, which is the primary U.S. objection. We assume it will halt future plans to bolster the tax.

But we have long felt that it is reasonably likely that Canada removes its digital services tax as a concession during trade negotiations with the U.S. That seems even more likely with this additional threat in place. Removing the tax would only forgo around $3 billion in Canadian revenue per year, whereas being subjected to Section 899 would cost several times that.

-JN

Polarization in the U.S. appears to be rising

Polarization in the U.S. is high and seemingly rising. This can be measured in a variety of ways.

Political partisanship has increased and is by some measures now at its most extreme level going back well over 100 years (see next chart).

U.S. Congress partisan polarization has intensified

As of 06/16/2025. Measured as the difference between median scores for the Democratic and Republican members in the House of Representatives and Senate. Sources: Voteview.com, RBC GAM

Another way of gauging partisan polarization is the extent to which Republican-leaning households feel differently than Democratic ones about economic conditions (see next chart). In the 1980s, 1990s and even 2000s there wasn’t a huge difference between the parties. More importantly, households’ assessments didn’t change on a dime when the political leadership changed. But in the 2010s and 2020s, the divide between the two camps has become incredibly large, even though both are living within the same economic landscape. It is hard to fathom that households’ assessment of the economy can change so completely immediately after an election.

Republican less Democratic consumer confidence

As of 06/2025. Sources: University of Michigan, Macrobond, RBC GAM

Anecdotal examples of this polarization include:

• the January 6, 2021 breach of the Capitol Building

• culture wars over the COVID-19 response and vaccine requirements

• fiercely contested Supreme Court nomination battles

• recent nationwide protests against the President, and the federal deployment of the National Guard and Marines to address California protests.

This last item highlights a relatively newer dimension to the polarization, as a state (California) is now in sharp conflict with the federal government.

This polarization threatens to affect the economy. We continue to look for evidence of damage.

The fact that one party’s members can be enthused about the economy and the other concerned about it argues that people are becoming unmoored from the economic fundamentals.

It isn’t yet clear that polarization is having a major effect on business decisions. Business interactions require a lot of trust – trusting that a company will pay its accounts payable and that items ordered will be as specified and of the expected quality. That trust still seems to exist, with political affiliation only rarely entering the equation.

However, there is evidence of erosion elsewhere.

The fact that one party’s members can be enthused about the economy and the other concerned about it argues that people are becoming unmoored from the economic fundamentals. In turn, they are more likely to make bad decisions, such as spending/investing/hiring too much or too little relative to what the actual economic environment dictates.

Another possible example of polarization-related effects is that the U.S. risk premium in the bond market has begun to rise – discussed in more detail later.

We are at a point where U.S. polarization may start to have adverse economic effects, in terms of a higher hurdle rate for investment decisions and the sub-optimal deployment of spending, capital and labour. It is unlikely to be a dominant determinant of economic growth, but it may play some role.

Academia remains under pressure

The White House is now investigating many American universities and several elite universities are now grappling with sizeable federal funding cuts. The White House is also attempting to block Harvard University from admitting foreign students. There may be more actions to come.

The direct effect of funding cuts is to reduce the amount of research that these institutions can do, incrementally undermining the innovation occurring within the U.S. economy.

Second-order effects are that if foreign students and professors are discouraged or outright blocked from engaging with U.S. schools – and if American professors find they can secure more research funding outside of the country – there may be a sizeable brain drain that prevents the next generation of global innovators and risk-takers from contributing as substantially to the U.S. economy as prior generations did.

Both of these forces threaten to reduce the long-run rate of U.S. economic growth, though of unclear profundity.

There are of course opportunities for other countries should they manage to attract a significant fraction of this displaced talent, research and innovation.

U.S. term premium continues to rise

The U.S. bond-market term premium has increased substantially in recent months, building upon a multi-year upward trajectory (see next chart). That means investors in longer-term bonds are demanding (and receiving) a premium in the form of a higher coupon than if they held a succession of short-dated bonds over the same time period.

Term premium is rising quickly

As of 05/22/2025. Sources: Federal Reserve Bank of New York, Macrobond, RBC GAM

This development is somewhat masked by that fact that longer-dated yields have remained roughly steady across the last few years. But what is happening is that the expected policy rate is falling over the long run, the expected inflation rate is remaining roughly unchanged over the long run, and therefore the term premium is rising (see next chart sequence).

Disaggregating bond market movements reveal rising term premium

As of 05/22/2025. Sources: Federal Reserve Bank of New York, Bloomberg, Macrobond, RBC GAM

Why is this happening? For a mix of reasons.

1. The term premium was unnaturally narrow (indeed, non-existent) for much of the 2010s as distortions such as quantitative easing and risk aversion made their presence felt. Some of the recent movement is just a natural decompression as quantitative easing has ended and more normal risk appetites return.

2. Another factor is that the U.S. is running a big fiscal deficit, with more planned based on the budget bill passing through Congress. That means there will be a large supply of bonds to absorb, and similarly that the risks around the U.S. public debt have risen somewhat – as per the latest debt downgrade. Reflecting some of this, it is now slightly cheaper for a top-rated U.S. company to borrow money than it is for the federal government (see next chart).

U.S. Treasury duration-adjusted yield now exceeds that of U.S. AAA corporates

As of 05/31/2025. Sources: Bloomberg, RBC GAM

1. Trust in the U.S. and the dollar’s status as the world’s reserve currency has eroded somewhat. Other assets such as gold and a handful of other currencies are taking up some of the slack. This is to say that foreigners are somewhat less inclined to hold U.S. debt. In turn, the cost of U.S. borrowing over the long term has gone up.

We believe the U.S. term premium may continue to widen somewhat further as these forces continue to take hold. It may not be the case that long-dated yields actually rise, but instead that they prove more resistant to declining than normal, even as the Fed and other central banks deliver additional monetary easing at the short end. A steeper yield curve is the likely result.

For the economy, a bigger term premium matters -- not just because it eats government money in the form of debt-servicing costs, but also because it represents a higher hurdle rate for investment decisions across the economy, incrementally discouraging such activities.

Japan’s higher borrowing costs

It should be conceded that the U.S. is not the only country experiencing higher long-dated borrowing costs. Japanese government bond (JGB) yields have increased by even more year-to-date (see next chart), and the yield curve is now quite steep as well.

Long-term government bond yields retreated recently after a reciprocal tariff induced surge

As of 06/13/2025. Sources: U.S. Department of Treasury, Macrobond Financial AB, RBC GAM

The increase in Japanese yields, particularly at the long end of the curve, reflects several factors:

1. A long-awaited exit from disinflation/deflation has forced nominal yields to rise amid higher “breakeven” inflation compensation. Inflation has risen by more than nominal yields, with the effect that real cost of borrowing is no worse than before.

2. The BoJ has relaxed its grip on the JGB market and is gradually shrinking its enormous bond holdings; it is also raising its policy rate as other central banks move in the opposite direction. This is to say that the central bank wants interest rates somewhat higher than before, and the bond market is obliging. It is certainly in the long-term best interests of the bond market that the central bank no longer holds over half of the country’s outstanding government debt (for comparison, the U.S. Federal Reserve holds less than 20% of U.S. debt).

The BoJ still owns half of outstanding Japanese government bonds

As of April 2025. Sources: Bank of Japan (BoJ), Macrobond, RBC GAM

1. Growing concerns about fiscal sustainability and rising term premia globally are impacting highly indebted Japan, where calls to increase defense and domestic spending are also growing. This is not unwelcome as it represents a useful nudge for the politicians, even if our Fiscal Health Index shows that Japan’s overall fiscal situation isn’t quite as bad as its record public debt-to-GDP ratio would suggest.

   This is all to say that while the recent Japanese bond market adjustment has been volatile and occasionally painful for investors, some of these developments are actually healthy. Japan has escaped a disinflationary trap, the JGB market is becoming less dominated by the BoJ, and investors are starting to impose some fiscal discipline on the country.

2. A valid remaining concern is that Japan’s longer-dated government bond auctions have struggled recently. The country does ultimately have to find buyers for its debt. One problem is that Japanese pension funds, a key traditional source of super-long JGB demand, are no longer buying so many, creating a supply-demand imbalance. Japan’s Ministry of Finance is reportedly considering reducing its super-long bond sales and reallocating some issuance to shorter tenors where demand is greater and borrowing costs are also lower.

-JN

Canadian inflation is rising

Canadian inflation came in fairly hot in April once the artificial effect of the carbon tax elimination was factored out. Components such as natural gas prices, travel tours, financial services, rent and vehicle prices all exerted some upward pressure.

Notably, these are not tariff-associated forces. As such, Canada finds itself in the opposite position of the U.S. in experiencing higher inflation in the lead-up to tariffs. Real-time inflation metrics argue that Canadian inflation may have remained warm in May and early June.

April’s firm inflation data contributed to the Bank of Canada (BoC) extending its pause in June. A further increase in unemployment since then opens the door to further easing. The futures market is still pricing in one more rate cut by year end – but further sticky inflation could give the BoC second thoughts.

While we budget for some increase in Canadian inflation from here due to tariffs – largely because the Canadian government has imposed tariffs of its own on the U.S. – the effect should be relatively small. Our updated tariff modelling currently argues for a mere 0.3 to 0.5ppt increase in Canadian inflation.

Supporting the idea that the inflation effect should be relatively small, the federal government acknowledges that its announced tariffs on the U.S. are only hitting at about 70% of their theoretical impact due to a proliferation of company-by-company exemptions. Some private sector forecasters argue that tariffs are binding at a much lower rate than that – as little as 30%.

Written by Eric Lascelles, except where otherwise indicated.

Research by Eric Lascelles, Josh Nye, Vivien Lee, Ana Ardila and Aaron Ma