Year of the tariff kicks off with a bang

US tariff threats against Mexico and Canada raises risk of massive trade war

For the time being, Trump has delayed implementation of the tariffs against Canada and Mexico by one month – to 1 March – after phone calls with their respective leaders. But his rhetoric has taken a hard line, saying “they owe us a lot of money, and I’m sure they’re going to pay.” Even if tariffs don’t go ahead in the near term, the risk will remain elevated.

Trump has also sought to prepare the public for the massive disruption that is likely to result from tariffs, acknowledging that “we may have short term some little pain.” This would come from three main channels: 1) Canada and Mexico have vowed a massive retaliation in the form of tariffs on US imports, 2) higher US inflation (see below), 3) US companies with complex cross-border supply chains, such as auto makers, which may see a compounding effect of tariffs where goods cross borders multiple times. As ‘painful’ as all of this may be, Trump’s comments suggest a high bar for him to permanently climb down from tariffs. If anything, as we describe below, there might be a lower bar for him to expand his trade war.

What else could stop tariffs?

If the potential economic pain of tariffs doesn’t stop Trump, what else could? The first is legal challenges. Trump has invoked national security – citing the inflow of fentanyl and illegal migrants –to declare an emergency, which enables him to impose tariffs with executive orders, thus bypassing Congress. This opens tariffs up to legal challenges in the courts, and the courts may then overturn the tariffs. The likelihood of legal challenges succeeding is arguably lower in Trump’s second term, however, as the recent suspension of the TikTok ban illustrated. In his second term, Trump seems increasingly willing to defy legal constraints, daring the courts to challenge his actions.

The second challenge to tariffs could come from the electorate. If people start feeling the hit in their pockets through higher inflation, or businesses impacted start shedding jobs on a meaningful scale, public opinion (even among the MAGA base) could turn against Trump. But this would likely take time to play out, if at all.

Perhaps the biggest hope to avoid tariffs comes from financial markets. Equity markets opened around 1.5% lower following the threat of tariffs over the weekend. Should a stock market sell-off intensify into more sustained downturn, Trump might be more willing to look for a face-saving climbdown (this may have been what drove the delay to the Canada and Mexico tariffs).

If sustained, what would the tariffs mean for the US economy?

Canada, Mexico and China are three of the US's top four trading partners, accounting for 42.5% of US goods imports. Tariff rises on imports from these countries would raise the trade-weighted average tariff from about 2.5% to 11% overnight, though this would gradually decrease as trade flows adjust (due to trade rerouting/diversion). This could result in a hit of about 0.8-1.1% to US GDP, occurring quite rapidly. Core inflation would increase by about 0.6-0.7% over the coming months.

A significant portion of the headline inflation impact would be avoided, as energy imports, which account for over 30% of imports from Canada, would ‘only’ be subject to a 10% tariff. Still, crude oil imports from Canada make up 60% of total US oil imports, likely leading to unpopular increases in gasoline prices. The automotive industry would be particularly affected due to its reliance on the USMCA (the successor to NAFTA) to maintain highly integrated cross-border supply and production chains.

And for Canada, Mexico and China?

For Canada and Mexico, these tariffs would be a significant blow. Exports to the US account for 74% and 80% of all exports for Canada and Mexico, respectively, and 20% and 26% of their total GDP. While a large portion of this is re-exports, the tariffs would have a substantial impact on their economies if tariffs remain in place long-term. In response to the US threats, Canada proposed 25% tariffs on a third of US goods imports, carefully targeting them to minimize the impact on Canadian consumers. Mexico would be expected to take similar action, and there have been suggestions that Canada and Mexico might coordinate their retaliatory action to maximise its impact.

For China, the impact of an additional 10% tariff on exports to the US – approximately a doubling of the current tariff rate – looks manageable. First, because the US share of Chinese exports has fallen since the first trade war in 2018-19, from around 19% in 2018 to around 14.5% in 2024, and is much lower compared to those of Canada and Mexico – also in GDP terms (just below 3% in 2024). Moreover, an additional 10% tariff is relatively small in terms of the usual volatility of exchange rates (with the yuan likely to depreciate further versus USD), selling prices and the margins of exports and importers. All in all, also reflecting our expectation of a further stepping up of monetary easing and fiscal support, partly contingent on the effective implementation of higher US tariffs, the overall impact of an additional 10% tariff is not a real game changer for Chinese growth so far. Note that in our base case we expect the US to gradually step up China tariffs much further, to an average effective rate of 45% in Q2-2026. See for more background our US-China tariff update published earlier today here.

What about Europe?

There would be little direct effect on Europe, which might even see a slight increase in exports to substitute goods from Mexico and Canada. But Trump has the EU firmly in his cross-hairs, with him stating he would ‘definitely’ impose new tariffs on EU goods, and that “it’s an atrocity what they’ve done.” What, then, do the aggressive tariff threats of recent days signal about Trump’s approach to Europe?

On the one hand, if the tariffs are sustained and they are as damaging as we think they would be, Trump could be sufficiently distracted by the brewing crisis in his backyard and may not want to compound it by bringing another party into the trade war. On the other hand, the lack of restraint against Canada and Mexico suggests the EU could be in for much bigger tariff rises than in our base case. Our base case assumes much more gradual and variable tariff rates on EU goods, with an average tariff rise of 5pp on EU goods, and big rises reserved only for goods where US companies directly compete. This is in line with what key figures on Trump’s economics team had indicated. But his moves against Canada and Mexico suggests Trump has little interest in the views of his advisors and appears to favour massive, across the board tariff rises regardless of the damage they do even to the US economy.

While uncertainty is high, this would imply a scenario closer to our first alternative tariff scenario laid out in our Global Outlook last November. For instance, with a 10% tariff on all eurozone exports to the US, exports to the US would fall by around 1/3, hitting growth by around 1.7pp over two years relative to a scenario of no tariff rises, and triggering an economic stagnation in the eurozone. Should we see tariffs of 20%, the shock would become non-linear in nature, leading to second round effects such as widespread job lay-offs, hits to confidence and a tightening of financial conditions. This would cause a severe recession in the eurozone.

Base case unchanged for now

Given the fluidity of the situation, we are keeping our base case unchanged for now. We had already been on the pessimistic side of consensus when it came to the growth impact of tariffs, with our eurozone growth forecast for 2026 at 0.8% vs 1.2% consensus. But while we thought that 2025 would be The Year of the Tariff, president Trump has surprised even our expectations in how aggressively he has pursued his flagship economic policy. As such, we judge the risk of the more negative scenarios outlined in our Global Outlook has risen significantly. We will update in the coming days with a potential update to our base case.