(Editor's Note: In this series of articles, we answer the pressing Questions That Matter on the uncertainties that will shape 2025—collected through our interactions with investors and other market participants. The series is aligned with the key themes we're watching in the coming year and is part of our Global Credit Outlook 2025.)

Trade protectionism has been rising globally in recent years, as is the risk for more, rather than fewer, of these policies in 2025. Tighter restrictions on global trade often have a negative impact on real GDP growth and could weaken financial conditions if they materially increase inflation and, consequently, interest rates.

How This Will Shape 2025

Uncertainty over trade policy adds complexity.   Amid two protracted military conflicts and ongoing U.S.-China diplomatic tensions, the global credit landscape is already fraught with challenges. The situation is set to become noisier with more trade protectionism likely in 2025 following the outcome of the U.S. presidential election. At present, the lack of clarity from the incoming administration about additional tariffs (scope, severity, and timing) introduces volatility. Furthermore, a cascade of second order effects, such as retaliatory tariffs, could occur. This uncertainty alone could keep higher-than-normal risk premia on credit. As expectations shift and specific trade policies are announced, periods of high volatility are likely.

Higher costs, higher inefficiencies.   The backdrop of higher trade protectionism and geopolitical tensions could speed up the ongoing relocation of supply chains. This surety of supply comes at a cost premium. Starting with Trump's first term and accelerating during the COVID-19 pandemic, manufacturers sought to improve resiliency of input shipments while maximizing profitability. Even before the U.S. elections, issuers in certain labor-intensive sectors, such as textiles, have relocated manufacturing production outside of China due to favorable trade terms (less expensive and large labor force). This is less of a concern for more capital-intensive sectors, such as tech and pharma, given need for specialized workforce and higher barriers to entry from established logistic chains. Relocating further production in those sectors could take time, especially if they receive government support. In the meantime, businesses may need to contend with higher costs and lower productivity.

Some wins, some losses.   Higher tariffs would benefit certain domestic-focused sectors, but many companies could face more challenging operating conditions. However, tariffs may bring a host of economic risks for those that cannot compete with cheaper imports. Higher input costs will at least partially be passed on to consumers, reducing their buying power and potentially depressing demand. In extreme cases, certain products may no be viable for production as they are no longer profitable. In such cases, limited top-line growth and narrower margins would pressure credit quality. Meanwhile, trade protectionism initiatives (e.g., EU's levy of high tariffs on electric vehicles [EVs] from China) could also be used to give time for industries to adapt to greater foreign competition.

Consumers draw the shorter end of the stick.   A wedge between winners and losers is set to deepen. Higher tariffs would benefit certain domestic-focused sectors amid higher barriers of entry, limiting competition. However, many companies could face more challenging operating conditions with costlier inputs. Although companies could pass some of these costs on to consumers, high prices could prompt consumers to reduce purchases, testing the elasticity of demand. Limited top-line growth and narrower margins would pressure corporates' credit quality.

What We Think And Why

Real GDP growth could suffer.   The higher associated costs of inputs for manufactured goods, as well as for final goods could result in lower consumption. The potential for re-location in supply chains to adjust to a new tariff regime could also increase costs of production, lowering firms' margins and increasing the prices of final goods. For producers, a test on cost pass through to customers will ascertain the extent of margin compression. Through the recent inflationary period—initiated partially by supply chain shocks—the companies that have fared best against margin pressures have included primary health care providers, regulated power companies with profitability protections, and essential transportation sectors, along with the industries that provide related fuels.

Goes beyond China.   While the focus of the incoming U.S. administration is likely to remain on lowering imports from China, tit-for-tat retaliatory measures are likely to spread around the globe. Goods with Chinese content produced in third parties could also be targeted. For instance, Vietnam has become a large exporter of goods to the U.S. while increasing its imports of intermediate goods from China (which are now 35% of total imports). Mexico, the largest source of imports to the U.S., has also seen a steady increase in intermediate Chinese imports. A review clause due on 2026 for the U.S.-Mexico-Canada (USMCA) trade agreement could also lead to uncertainty on trade policy among those countries throughout 2025, when negotiations will likely start.

Tension to rise. Fears of Chinese manufacturers flooding markets with cheaper products could spike tension among some domestic producers. This is already seen in the European auto sector, where concerns of influx of Chinese EVs could weaken sector dynamics. Similarly, small medium enterprises may falter against price wars amid high-cost bases.

Tighter financial conditions.   The initial increase in inflation that would follow higher tariffs would likely at least slow the U.S. Federal Reserve's (the Fed's) efforts to ease interest rates, as well as other central banks around the world. The combination of higher interest rates, U.S.-centered tariffs, and risk aversion would likely strengthen the U.S. dollar. Higher risk aversion, combined with uncertainty over the fiscal path of the U.S., could increase term premiums, pushing up long-term U.S. treasury yields. Outside of the U.S., issuers with large external financing needs (particularly, emerging market borrowers) could be vulnerable to a costlier dollar. With offshore or USD financing options narrower, onshore financing activities will likely dominate.

"National security sectors".   Certain sectors that have been identified as associated with national security are likely to be the main source of trade tensions. These sectors have already been targeted by the outgoing U.S. administration, and there is political consensus to continue pursuing those policies under the incoming administration. There are significant efforts underway to "re-shore" the production of those goods. Concerns related to national security can range from direct threats to the development of defense capabilities to indirect impacts on economic stability. In certain cases, new restrictions go beyond tariffs and ban the imports and outside investments in certain products entirely.

Specialized manufacturing could be vulnerable.   We expect the hardest hit industries will be those with highly engineered products dependent on international suppliers for specialized manufacturing. The facilities required to make these types of products are expensive to relocate and hardest to staff. Additionally, sensitivities around intellectual property and proprietary manufacturing processes tend to encourage avoiding redundant facilities or elevated levels of turnover. Components in this category include semiconductors and electrical components supplied to technology companies, but also apply to utilities focused on renewable energy. Utilities with renewable energy investments require highly engineered components for solar panels, wind turbines, and battery chemistries. Fortunately, the end products associated with these components tend to have the highest margins and may therefore have some room to absorb rising input costs.

Adjusting quickly.   We anticipate sectors with more commoditized international inputs will be able to adjust more quickly. Sectors such as consumer products, retail & restaurants, health care, and homebuilders/building materials will be affected as well. However, to the extent that they are dependent on more commoditized imports, they should have more success finding alternative suppliers or moving operations quicker and at a lower cost. Nevertheless, they are likely operating under tight margins and will be vulnerable to anything that extends their transition period.

What could change

Tariffs could turn out to be a negotiation tactic to secure non-trade-related interests.   While some extent of higher tariffs announced by the next U.S. administration is very likely, the magnitude and duration of those policies could be lower and shorter-lived than what most anticipate. Tariffs, under the previous Trump administration were used as a bargaining tool to achieve other objectives (higher purchases of U.S. agricultural products, for example).

Stimulus measures could offset the economic impact of tariffs. The impact of tariffs on real GDP growth could be offset by fiscal measures, especially if those policies take a toll on strategically important sectors. Some of these measures could include subsidies to affected sectors and/or support for households to manage higher prices of final goods. However, this pushes back fiscal consolidation across governments, ensuing higher government debt stock.

Retaliatory tariffs and other second-order effects could change the trajectory of current protectionist policies.   As trade policies continue to unfold and national economies react, trading agreements will naturally be fine-tuned. In the past, we have seen specific sectors excluded or certain nations benefiting from favorable terms of trade. These developments would likely also incorporate how ongoing geopolitical conflicts evolve and the extent to which sanctions among countries strengthen or weaken.

Read More

• How Would China Fare Under 60% U.S. Tariffs?, Nov. 18, 2024
• How Could A Second Trump Term Affect U.S. Credit?, Nov. 7, 2024