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Trade tensions are threatening what has been a favorable credit environment for most borrowers. The April 2 tariff announcements by the U.S. (and the subsequent escalation in the trade conflict between the U.S. and China) went far beyond what financial markets had imagined and exceeded our previous assumptions. If the paused U.S. tariffs are implemented in full, the economic and credit fallout would be broad and deep.

What We're Watching

The Trump administration's 90-day pause of most tariffs didn't remove the uncertainty for credit conditions. Unresolved trade tensions as the partial pause approaches its end could have a visible impact on credit quality and heighten market volatility. The breadth and depth of the effects will depend on the duration of tariffs, countermeasures by the U.S.'s trading partners, and any stimulus that governments put in place to offset the economic impact.

The prevailing uncertainty is likely to further undermine business and consumer confidence, heightening concerns about corporate investment, employment, consumer spending, and overall economic activity.

In the short term, the effects will be on funding, with many borrowers having to pay more for financing (or, worse, find themselves shut out of the capital markets). Banks or other intermediaries could become more risk averse, so as not to be caught by asset-valuation swings or limited liquidity. In the longer term, the effects will likely slow economic activity, further disrupt global supply chains, and fracture geopolitical relationships.

Emerging markets in Asia and Mexico are among the most directly exposed to a reinstatement of the U.S. tariffs announced April 2, due to their strong export links. Most have opted for negotiation over retaliation, unlike China. U.S.-China tensions are escalating, and China's export engine could face material disruption if current U.S. tariff levels on China stay for a prolonged period.

What We Think And Why

The most imminent risk to credit in this environment is market volatility and increasing investor risk aversion.

Sharp declines in equities could force market participants to sell safer assets to raise liquidity to meet higher margin requirements. This, in turn, could set off a decline in prices for a broader set of assets, including Treasuries. The inability of a counterparty to post margin could also lead to major market disruption, leading to contagion and concerns about the creditworthiness of a broader set of counterparties, particularly in the banking space.

While borrowers entered this period with solid credit fundamentals (having benefited from a stretch of supportive conditions), some lower-rated borrowers could ultimately be shut out of the capital markets until more clarity appears. This could push default rates upwards toward our pessimistic scenarios of 6% in the U.S. (from 4.7% as of February) and 6.25% in Europe (from 4% in the same period) by year-end.

For corporate borrowers, we would expect both direct and indirect effects to weigh on ratings. The overall potential for a hit to business confidence and greater uncertainty around trading could erode previously improving momentum in profits growth and pause investment, hiring, and acquisition plans.

We expect the overall slowing of global economic activity to weigh on the growth of financial institutions, particularly in countries targeted with the most severe levies, which would weaken business and consumer confidence. For sovereigns, the key risks over the next quarter emanate from the secondary effects of trade instability.

What Could Change

Given the intensifying global trade —and the potential effects on economies, supply chains, and credit conditions around the world—our forecasts carry a significant amount of uncertainty. As a result, we are taking a measured approach to rating changes and evaluating the impact on a credit-by-credit basis since supply chains can vary greatly for similar entities. As situations evolve, we will gauge the macro and issuer-specific credit materiality of potential and actual policy shifts and reassess our guidance accordingly.

The tariffs, if fully implemented as per the April 2 announcement and remaining in place for our forecast horizon, would weigh on GDP growth globally.

We haven't yet revised our most recent macroeconomic forecasts. Excluding the effects of escalating U.S.-China trade tensions, we believe the partial pause announced by the Trump administration on April 9 (which still includes 10% blanket tariffs for all trading partners apart from China) will lead to a moderate overall impact compared with the assumptions we have used. We project the global economy would expand just 2.7% this year and next—about 0.3 percentage point lower than our most recent forecast. (Note that these figures don't fully account for the recent escalation between the U.S. and China.)

In such a scenario, we think U.S. GDP would expand just 0.9% in the fourth quarter (annualized), with full-year growth of 1.6% this year and 1.5% next year—both down 0.4 percentage point (ppt) from our March forecast. This would also raise the likelihood of recession in the world's biggest economy and influence our expectations of future rate cuts and currency movements.

We project such a scenario would also shave about a quarter percentage point off eurozone GDP growth in the next two years. The Asia-Pacific region's biggest economies would likely see reductions of 0.2 ppt-0.4 ppt in growth in 2025 and 2026, respectively. In emerging markets, smaller and more open Asia-Pacific countries would see the biggest impact to GDP growth, ranging from 1.0 ppt-1.8 ppt in 2025 and 0.6 ppt–1.2 ppt in 2026.

Writer: Molly Mintz