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So it’s on. The trade war we all feared but hoped would never happen exploded this past week. Who knows where it will end.

The world has not seen anything like this since the 1930s when President Herbert Hoover signed the Smoot-Hawley Tariff Act. That set in motion a series of international retaliatory actions that slashed U.S. exports by 61 per cent and imports by 66 per cent between 1929 and 1933.

And what did that do for the U.S. economy? Gross national product dropped 46 per cent in that period. The unemployment rate in that country rose from 8 per cent at the time the Act was signed to 25 per cent four years later.

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None of this has deterred U.S. President Donald Trump and his advisers from embarking on the same protectionist journey. There are some who claim this is just an aggressive negotiating tactic by the President to get a better NAFTA deal. I don’t think so. Mr. Trump is proving to be an ultra-conservative ideologue who is doing everything he can to implement his beliefs.

He has already indicated that he will not stop with steel and aluminum when it comes to Canada. He now has our auto industry in his sights – about 80 per cent of the cars we build are exported to the United States. And on Friday, he tweeted again about how U.S. dairy farmers were being mistreated by Canada’s supply management system and took another swipe at our lumber exports. It appears there is more bad news to come from Washington.

Canada’s response may seem huge in our terms, but it’s a pinprick for the U.S. economy. Slapping tariffs on items as diverse as ketchup, toilet paper, playing cards, soy sauce and inflatable boats, as well as U.S. steel and aluminum, will inflict minor pain on some U.S. companies, but it will be nothing like what we are likely to experience.

So far, the markets appear to have taken all of this in stride. The Dow was up by triple digits on Friday and the Toronto Stock Exchange was down only modestly. But investors may be whistling past the graveyard.

Let’s consider the best and worst things that may flow from this situation. The best-case scenario is that this is indeed a negotiating tactic that works. Canada and Mexico bend on their positions regarding the North American free-trade agreement and the United States softens just enough to get a quick deal that satisfies the President while leaving the other two partners with a modicum of dignity. A memo of understanding is signed within a month, the metals tariffs are revoked, as are the retaliatory measures, and life in the North American trade world returns to a degree of normalcy. I put the odds on that happening at 25 per cent at best.

The worst-case scenario would unfold over a longer time period. In the initial stage we would see a decline in Canadian steel and aluminum exports to the United States and corresponding layoffs in the affected industries. We would also see consumer prices begin to rise on targeted U.S. imports.

Rising prices would boost inflation, which is already close to the Bank of Canada’s 2-per-cent target and is expected to rise due to higher gasoline prices. That in turn would increase the pressure on the central bank to raise interest rates. The result would be to push the loonie higher, making our exports even less competitive and putting the squeeze on highly indebted mortgage holders.

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Higher interest rates would further erode the market price of bonds, certain types of preferred share and interest-sensitive stocks, such as utilities and telecoms. We have seen evidence of this already. On the other hand, higher rates could boost the earnings of banks and insurance companies, provided they did not lead to widespread bankruptcies.

If the trade war becomes as nasty as it did in the 1930s, the global economy, which has become increasingly interdependent, will falter. Recession or even depression in many countries is the probable outcome.

As an investor, what should you do? Here are some suggestions.

Reduce exposure to Canada. We will fare far worse than the United States in a trade war, and growing uncertainty about the future will curtail capital investment. Apart from financial companies and the newly revived energy sector, there are few areas of the TSX that inspire confidence. One exception: Companies that do a lot of business in the U.S. and are not hit by the new tariffs.

Increase exposure to the U.S. Mr. Trump has proven he is no friend to Canada (or any other ally, for that matter). However, his policies have revitalized the U.S. economy, particularly with the corporate tax cut and the slashing of crippling regulations. Unemployment in the United States is below 4 per cent, the lowest in almost two decades, and the American stock market continues to hit new highs.

Raise cash. If the worst-case scenario unfolds, the world economy will eventually tank. At that point, you want to be in a position to take advantage of the bargains that will emerge, as they did in 2008.

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We are now sailing in waters not seen in almost 90 years. There is no way of knowing how it will all turn out but we should be prepared for anything.

Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to www.buildingwealth.ca.

Follow Gordon Pape on Twitter at twitter.com/GPUpdates and on Facebook at www.facebook.com/GordonPapeMoney

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