Tariffs: A rough road leads to new destinations

It has been said that history doesn’t repeat itself, but it often rhymes. Canada is not totally unfamiliar with unilateral measures to limit its access to US markets, albeit not with today’s extraordinary volatility and intensity.

Concerned about the erosion of American economic power, US president Richard Nixon implemented a series of globally disruptive policies in 1971 that came to be known as the “Nixon Shock.” These included a 10% tariff on all imports. Canada was not exempt.¹

Prime Minister Pierre Trudeau tried to negotiate a softer landing. When his appeal failed, External Affairs Minister Mitchell Sharp penned a landmark paper, Canada-US Relations: Options for the Future, calling for a “Third Option.”² Instead of simply accepting Nixon’s new status quo or pursuing ever-closer economic integration (Options 1 and 2), Canada, Sharp argued more than 50 years ago, should opt to diversify its trading relationships while adopting an industrial policy to foster greater self-sufficiency.³ Or as Mark Carney put it more recently: “We cannot control the storm blowing in from Washington. We can chart a new course by building Canada strong at home and diversifying our trading relationships abroad.”⁴

The well-intentioned Third Option never went anywhere; there were far fewer importing nations with which to diversify in the 1970s and Nixon withdrew his tariffs after several months, killing any sense of urgency. Today, Canada’s reliance on the US as our primary buyer of exported goods is marginally greater than it was when Sharp penned his treatise and so – as has become starkly clear in the summer of 2026 – is its vulnerability. 

Ten percent tariffs sound almost quaint measured against the numerous Canadian sectors now facing levies as high as 50% under US President Donald Trump – with the threat of more to come.

Meanwhile, some attempts to reduce dependence on a single market – such as Canada’s deal to import a small number of Chinese EVs at light tariffs in exchange for lower trade barriers on canola⁵ – raise the risk of opposition from our largest trading partner. In the 2018 NAFTA renegotiation, the US insisted it would have a say in any comprehensive trade agreement with a non-market economy (ie. China).⁶ Canadians have said similar demands were made in the recently suspended negotiations.⁷

Prime Minister Carney’s core policies – building a stronger Canadian economy with more diversified trading relationships – carry echoes of past responses from Sir John A. Macdonald’s National Policy to Sharp’s Third Option. But such transitions are never easy. Effective trade diversification means being open-eyed about which export sectors have the most to lose and gain, how plausibly these can be tilted toward new markets, and the extent to which new products must be part of the mix.

To answer those questions, the Future of Canada Centre and Deloitte’s Economic Advisory practice have modeled two credible scenarios against a baseline ‘status quo’ as of July 1st, 2026.  

In the first scenario, CUSMA Withdrawal Scenario, the US withdraws from the Canada-United States-Mexico-Agreement (CUSMA) and tariff exemptions on all sectors end. Trade resets at Most-Favoured-Nation (MFN) rates that apply to member countries in the World Trade Organization. Additionally, we assumed a 10% global tariff imposed by the US affects previously CUSMA-exempt sectors, including oil-and-gas. The bottom line is a severe but not cataclysmic impact on Canada’s overall economy, although perhaps cataclysmic for some sectors. While we refer to this scenario as our ‘downside’ model, it’s clear from events in August 2026 that there is potential for much worse if the Trump administration imposes further punitive tariffs on Canadian goods, as it has stated will happen in January. However, given the high degree of uncertainty around how long such tariffs would last, which sectors they would cover, and whether they would withstand legal and political challenges, we have opted to use the permanent and legal withdrawal from CUSMA as a proxy for the exposure of further sectors to new tariffs. 

In our second scenario, the Accelerated Diversification Scenario, US tariffs remain at July 1st levels – the baseline – but Canada responds by both maintaining its existing panoply of trade agreements and continuing to ink new ones. This assumption provides a useful upper-bound to what can be achieved by more diversified and unencumbered trade. The model indicates that while the pursuit of new markets will produce major gains, this upward potential is significantly less than the losses generated by Scenario One.

There are, of course, a myriad of other possible policy combinations. But the range between these two plausible scenarios – effectively waiting for the cornerstone Canada-US trade agreement to collapse versus taking proactive action to diversify now – amounts over 10 years to a swing of more than $500-billion – some of it lost real GDP and some new real GDP.⁸ This difference demonstrates the size of the hole Canada is seeking to plug and the scope of the rewards if we succeed.  

Scenario one: CUSMA withdrawal  

With the US accounting for approximately 70% of exports in 2025, Canada remains highly exposed to the shifting policies of a US President and administration highly skeptical of free trade and wedded to tariffs as a favoured instrument of policy.

This ‘downside’ scenario illustrates the extent of Canada’s vulnerability should the US formally withdraw from CUSMA (or some equivalent), a possibility that cannot be dismissed, given the need for only a six-month notice period. 

In this scenario, Canadian real GDP will fall by 1.6% by 2036 relative to the status quo baseline, representing $402 billion in lost real GDP over the decade. Domestic investment in things like infrastructure and machinery take a hit and employment is also projected to shrink by 163,000 jobs annually on average. Average wages would likely decline, cutting into domestic consumption and household purchasing power. The toll would be disproportionately felt in the early years as many Canadian companies face an immediate competitive disadvantage. 

Sectors that rely most heavily on exports as a percentage of their overall sales suffer the most. Manufacturing is especially vulnerable with motor vehicles and parts experiencing a 28% drop in real GDP by 2036 compared to the July 1 baseline. Electronics, machinery and equipment lose 21%, rubber and plastics products 20%, and chemicals 13% in real GDP by 2036 relative to the baseline. 

In this scenario, the model has not excluded oil and gas from the struggle. As relations deteriorate, it assumes Canada’s largest export category would come under the ambit of the US’s existing 10% global tariff, along with other sectors no longer protected by CUSMA exemptions. This, in turn, would see oil and gas exports to the US reduced by 11% and 30% respectively, relative to the baseline. Some of that loss could be mitigated by increased domestic sales as Canadian industry adjusts and by exports to new markets. But for this alleviation to happen requires additional production and infrastructure investments and the assumption that global demand remains strong. Even so, the net result would be a loss of 0.4% in real GDP for oil and 0.9% for natural gas by 2036.⁹ While Scenario One clearly demonstrates that the cumulative damage of a collapse in preferential trading arrangements with the US would be severe, its impact would not be cataclysmic. 

Even before taking steps to diversify our trade portfolio, some of the damage from shrunken trade with the US would be mitigated by the kind of natural reallocation economies produce when facing shocks. For example, while Canada’s exports to the US would be expected to plummet about 21% by 2036, compared to the baseline, total global exports would fall only half as much, or about 10.5%. That’s because the oversupply of some Canadian products previously bound for the US market would soften prices, boosting demand at home and in other markets. Meanwhile, US protectionism would drive up its production costs, allowing a more competitive Canada to capture some of America’s global market share for certain products. 

Scenario two: Accelerated diversification 

In the Future of Canada Centre’s ‘best-case scenario,’ Canada maintains all its existing free trade agreements while successfully negotiating new ones everywhere else. This scenario assumes CUSMA remains formally in place, although subject to the heightened tariff pressures that had already gained a foothold at the time of the July 1, 2026 baseline. This second scenario is meant to test the diversification proposition – in other words, what is the potential to redirect vulnerable Canadian exports through new and improved relationships elsewhere in the world. The model suggests that the gains from export diversification, while encouraging, are smaller in scale than the consequences of the break-down in preferential trade with the US envisioned in Scenario One.  

In pursuing more accessible global trade, real GDP grows by 0.6% in 2036 compared to the baseline, representing $141 billion in additional cumulative real GDP and the creation of an average of almost 53,000 jobs a year over the decade, one-third the number lost in the first scenario. 

Of course, diversification is not equally feasible across all sectors; some industries are more exposed to US demand and cross-border supply chains than others and don’t have ready alternatives. The central question for policymakers, then, becomes not whether Canada should diversify but where diversification will enjoy the biggest impact – and how much it can move the needle. 

In our best-case scenario, the biggest export gains are naturally seen in sectors where Canada already enjoys a strong presence and in markets where we are currently hobbled by relatively high tariffs.  

Agriculture (crop, animal production and food manufacturing) represents one of our highest potential growth sectors, particularly to the extent markets open in China and India. Our model¹⁰ shows crop exports to non-US markets increasing by $4 billion in 2036, while food manufacturing increases by $16 billion annually in 2036 relative to the status quo. 

Manufacturing of electronics, machinery and equipment also holds good potential for growth, with exports to non-US markets increasing by $3 billion as the sector’s real GDP rises 5% in 2036 compared to the baseline. Motor vehicles and parts exports to non-US markets increase by $1.1 billion by 2036 and the sector’s real GDP rises 3% by 2036 relative to the baseline. Transportation equipment manufacturing, and chemical manufacturing, are each projected to increase by about $1.0 billion, representing real GDP growth of 4% and 3% respectively. 

The net impact from these star sectors, while certainly positive, does not add up to an overwhelming number. Even if Canada were able to negotiate free trade agreements with the rest of the world, while tariffs with the US remained unchanged from our baseline, the cumulative impact on real GDP would be a gain of just of 0.6% by 2036, or about $141 billion. 

That does not negate the necessity of pursuing enhanced market-access wherever possible, but it does suggest that to be truly prosperous, Canada needs to do more than just find new markets for established products. It also needs to lean into policies that enable greater self-sufficiency – as per the Third Option – by breaking down internal barriers and developing new areas of specialization at home that lay the basis to competitively serve world markets. 

New markets, new products strategy 

The Canadian government has been pursuing new industrial investment opportunities with a sense of increasing urgency.  

Plans to massively increase government spending on defence includes billions of dollars allocated to a comprehensive Defence Industrial Strategy.¹¹ The trade goal is to increase defence exports by 50% over the next ten years.¹² It has been reported that Canadian defense companies are already looking at opportunities to utilize idle auto manufacturing facilities¹³ to more quickly boost their own production, the kind of pivot that will become even more important if the US follows through on imposing 50% tariffs on the auto sector in January 2027. 

The Major Projects Office is starting to get behind domestic investments aimed at increasing the capacity and quality of export infrastructure, thereby facilitating our ability to sell both existing and new products into markets further afield. The most discussed of these is critical minerals, where Canada has rich deposits and global demand is forecast to increase markedly in the coming decade. Value-added refining of those minerals – an industrial strength heavily concentrated in China – also is on the agenda. Through six sector-focused Workforce Alliances¹⁴, the government is hoping to reskill disrupted workers to focus on priority areas viewed as crucial to future economic growth. But projects need to get financed and built. 

From its inception, the Carney government has expressed a strong commitment to expanding both what it calls the clean energy and conventional energy sectors. In August, it announced what it says will be the largest energy investment in North American history on Canada’s East Coast.¹⁵ Among other things, a ready supply of green energy will allow the Labrador Trough, rich in high-purity iron ore, to gain competitive advantage for Canada in producing green steel.¹⁶ This could create another new sector that could benefit from demand changes in the marketplace. Canada’s strong presence in nuclear technologies could generate yet another lucrative export product while also supporting the soaring demands of AI. All these areas hold out promise of adding to Canada’s export portfolio. At the end of the day, though, while governments can help create the conditions to encourage Canadian companies to innovate into value-added products and compete in higher premium parts of the global market, this will depend on the appetite and skill of producers.  

Reducing internal trade barriers 

Finally, true prosperity also means changing the way we do business at home. While we may not be able to eliminate US tariffs, we can certainly remove our own internal trade barriers.

Earlier research by Deloitte Canada¹⁷ has shown that interprovincial exports’ share of the Canadian economy has remained largely unchanged for more than 30 years, standing at 18.1%¹⁸ of GDP in 2023, which is well below the contribution to GDP generated by trade with the US. Back in the 1970s, those percentages were essentially reversed. If Canada is to be tariffed by the US and is looking for offsetting economic gains, it can start at home. The Deloitte analysis, completed in 2025, showed that completely phasing out interprovincial trade barriers over five years would generate an additional $881 billion in economic output by 2040—a 2.4% GDP increase—and create 133,000 new jobs.¹⁹ Even achieving half of that would nearly wipe out the GDP losses from our downside scenario. 

Here, too, there is historical precedence running right back to Canada’s origins as a sovereign nation. 

In 1854, the US and British North America signed the Reciprocity Treaty, the first bilateral free trade deal between what would become Canada and its southern neighbour.²⁰ The deal established free trade in a range of what were then called natural products and gave fisherman on both sides of the border access to each other's coastal waters. The US cancelled the agreement in 1866, a decision that fortified the case for Confederation as a way of creating a larger unified internal economy better able to withstand external pressures and pursue international opportunities. 

Since then, Canada’s attempts to forge closer trading ties with the US have proceeded in fits and starts. Although the 1989 Canada-US Free Trade Agreement, which was superseded by the North American Free Trade Agreement in 1994, and then by CUSMA, produced solid gains for Canada, the popularity of continental free trade has waxed and waned at different times on both sides of the border. 

The lesson – which we have at times embraced but never convincingly stuck with – is that continentalism is – or was – the path of least resistance, but diversification nonetheless remains the handiest antidote to the dependence and vulnerability flowing from three-quarters of exports going to a single market. Just as portfolio managers hedge their risks, so do nations, especially in periods of intense global competition among the most powerful countries.  

Back in 1972, cultural inertia and regional divisions were among the headwinds blamed for the failure of the Third Option, along with a less developed global marketplace. Today, Canada has been shocked into a heightened awareness of vulnerability from one of the heaviest dependencies among major economies on a single market. 

The numbers tell the story. A continued deterioration of trade relations with that market will significantly but not irreparably harm our economy. But the shock and adjustment will be considerable. Diversification helps but takes time and doesn’t fill the entire gap. The development of new export sectors moves the yardsticks further along. Of course, the best solution is to both protect existing access to the United States and diversify into new markets and products. 

But Canada will have to play the hand it is dealt to the best of its ability. And that appears to closely resemble the largely abandoned Third Option strategy of more than half a century ago.