S&P Global Ratings Economics expects highly uncertain and volatile trade policy during the Trump administration. In comments shortly after taking office, President Trump suggested he could impose 25% tariffs on imports from both Canada and Mexico, perhaps as early as Feb. 1.

Our baseline economic forecast doesn't incorporate potential tariffs on Canada and Mexico--the country's two biggest trade partners (followed by China). President Trump linked his comments on tariffs to border security issues, and we expect both Canada and Mexico will be pragmatic in adopting border security measures to avoid any tariffs by the U.S., given their high integration into U.S. supply chains (see chart 1). However, given the high uncertainty around U.S. trade policy, we've estimated which sectors would be the most vulnerable to Trump's suggested tariffs on these countries.

Our results suggest that the auto and electrical equipment sectors in Mexico could face the largest downward pressure on output in the event of tariff increases. In Canada, commodity-related processing sectors would come under the most pressure. Several factors could cushion the decline in output, such as exchange rate movements, availability of substitutes, and the willingness of producers to absorb the higher cost associated with tariffs.

Chart 1

Our Scenario Assumptions

For this analysis, we assume a blanket 25% tariff by the U.S. on imports from Canada and Mexico, like the one suggested by President Trump. We anticipate Canada would then respond in kind by also implementing a 25% across-the-board tariff on U.S. imports. In the case of Mexico, we think it's very unlikely the government would place tariffs on U.S.-manufactured imports, given most are intermediate goods eventually exported to the U.S. Therefore, we expect the Mexican government could impose tariffs on agricultural and food imports, but not manufacturing. This would be similar to Mexican officials' response to U.S. tariffs on steel and aluminum in 2018, when they increased tariffs on about $3 billion in imports from the U.S., mostly in the agricultural sector.

Output At Risk Shows Sector Vulnerabilities

For our scenario, we focused on output at risk, which is the potential decline in output of a given sector from a tariff-induced demand loss. It considers global supply chain connections but keeps the global production structure constant, therefore delivering an estimate before dynamic adjustments--like exchange rate changes, production relocation, product substitution, or trade reorientation--take place. We use output at risk to highlight potential sector vulnerabilities.

We identified the top 10 industries hit by our tariff scenario (see charts 3, 5, and 7). The ranking incorporates both economic linkages as well as uncertainty about the demand response to tariffs (through elasticity uncertainty), as reflected in the ranges of the output at risk.

Mitigating factors

Several mitigating factors could soften declines in output considerably. One is producers' willingness to absorb the higher cost associated with tariffs. A significant share of trade within North America is intrafirm, which may encourage firms to absorb costs at the different stages of production.

Another factor is the low availability of substitutes in certain sectors, such as in the auto parts sector across North America.

Moreover, fluctuations in the exchange rate could absorb part of the price increase from potential tariffs. Both Mexico and Canada have floating exchange rates that can adjust rapidly, which means the long-term impact on output of an increase in tariffs could be considerably lower than the initial output at risk.

Canada faces highest risk in commodity-related processing

Canada's most vulnerable sectors, meaning those with the highest output at risk based on the global input-output table analysis under our tariff scenario, are its commodity-related processing industries (paper products, rubber, and plastics) and some manufacturing industries (machinery and equipment and chemicals). Sectors with wider ranges of output at risk--such as paper products and printing, at 9%-15%--face greater price or volume volatility, highlighting the higher uncertainty regarding the impact of the tariff-induced price shock (see chart 2).

Our estimates incorporate supply chain dependencies between Canada and the U.S. One indicator we use, which is tightly connected to the production structure of a country, is the value added in gross exports (see chart 3). The value added is split by domestic and foreign origin, where the line shows the share of domestic value added in exports of intermediate products used in foreign industries. This measure highlights two vulnerabilities:

• The dependence on trade and external value-added production stages in Canada's manufacturing industry, before exporting products; and
• Industries with the highest value added in intermediate goods, which foreign countries use as inputs (for example, the mining and quarrying industry).

Chart 2

Chart 3

Most value added in Mexican manufacturing comes from abroad

Sectors in Mexico face much higher output at risk than those in Canada. The electrical equipment and auto sectors are the most vulnerable, with the highest output at risk (see chart 4).

The data for Mexico illustrates its status as an assembly line within North American supply chains. Value-added shares across its total industries (except construction), and more specifically in its manufacturing and information industries, come predominantly from abroad (see chart 5). Indeed, Mexico's share of foreign value added for all industries (except construction) in its exports is about 17% higher than in Canada and 33% higher than in the U.S.

Chart 4

Chart 5

The U.S. would feel a much smaller impact from in-kind tariffs

Assuming Canada and Mexico also impose tariffs on the U.S., the most exposed U.S. sectors would be agriculture and fishing, metals, and autos (see chart 6). But the U.S. has a high share of domestic value added in its manufacturing sector--86%, compared with 50% for Canada and 64% for Mexico (see chart 7)--and stands at the center of the North American production network. This beneficial economic integration, paired with negative trade balances and a relatively low trade share of GDP, leads to pronounced asymmetries in our estimates of output at risk between the countries under our scenario.

Comparing the U.S.'s output at risk (chart 6) with Canada's and Mexico's (charts 2 and 4), our scenario suggests that Mexico and Canada face impacts on their whole economies that are 11x and 5x higher, respectively, than the impact on the U.S. If we limit our analysis to only the top 10 affected industries, the average impact is still 6x worse in Mexico and 5x worse in Canada than in the U.S.

Chart 6

Chart 7