Wall Street’s top investment banks are preparing clients for the worst possible trade war outcomes as the U.S. prepares to ratchet up its tariffs on goods imported from China, telling clients to “fasten your seatbelt and don’t hold your breath.”
Strategists from UBS to Bank of America detailed their worst case scenarios for the U.S., Chinese and European stock markets, with all forecasting more selling if Washington can’t remedy its trade spats around the world.
Market jitters stemming from an escalated trade fight between the globe’s two largest economies could be so bad that is could send the S&P 500 in a correction, wrote UBS strategist Keith Parker. In that bear case scenario, Parker added, European markets and cyclical U.S. sectors including metals, mining and automobiles could be in for the most pain.
Stock market impact
Parker said that UBS predicted a max trade-related sell-off of 19% back in the fourth quarter of 2018, but he now sees about 10% downside.
“With risks having increased, it is worth asking where the largest asset market moves could occur if trade tensions were to rise further,” the strategist wrote Tuesday.
Global equities have been on edge this week after President Donald Trump tweeted on Sunday that the current 10% tax on $200 billion worth of Chinese goods will rise to 25% on Friday. The Dow Jones industrial average is down about 450 points this week, while the S&P 500 shed 1.9%.
For its part, Bank of America Merrill Lynch said its bear case includes a U.S. tariff hike and a response from China on U.S.-made cars. Beijing could also decide to buy more soybeans from Brazil instead of the U.S., putting the pressure on farmers throughout the country.
“Fasten your seatbelt and don’t hold your breath,” Bank of America strategists wrote Monday. “The latest escalation of the trade war was completely unexpected, despite the strength of the economy and the markets. This is evident from the immediate negative reaction of U.S. equity futures to the news.”
But an inflamed trade war would have sizable impacts on European and Asian markets, too.
Based on models complied by UBS’ Parker, the Stoxx 600 index — which tracks large, mid and small capitalization companies among 17 European countries — could see another approximate slide of 7% if trade tensions worsen. The index is already 3.3% off its 52-week high.
He added that full-blown trade war would shave off 45 basis points from global economic growth, while China’s GDP would take a hit of between 1.2% and 1.5%.
For his part, Morgan Stanley Head of U.S. Public Policy Strategy Michael Zezas wrote that while his base case expects China’s GDP growth to recover to 6.5% in the second the third quarters, a U.S. tariff hike could cut that estimate by 0.3 percentage points.
“While we expect a re-escalation would be temporary, as market weakness would help bring both sides back together, any escalation inherently augments uncertainty and further undercuts risk markets,” Zezas said.
Further, if China responds by raising their weighted tariffs on $60 billion of U.S. goods to 15% from the current 7%, that could reduce U.S. GDP by 0.1 percentage points.
Negative surprises like a potential re-escalation of trade tensions can have a greater price impact than fundamentals might dictate, ” Zezas told clients. “Near-term downside risk for Chinese equities onshore and offshore could be down 8% to 12%, arguably the biggest among major markets we cover.”
Will Fed step in?
To be sure, trade deliberations aren’t the only force at play in the markets. Any continued turbulence between the U.S. and China could be mediated by the Federal Reserve by lowering interest rates, suggested DataTrek co-founder Nick Colas.
“With US equity volatility looking to rise this week, markets will inevitably back into an ever-stronger view that Fed policy will have to shift,” Colas wrote Monday. “On the plus side, that should limit daily slides in stock prices. On the downside, it paints the Fed into an ever-tighter corner. And it will force equity investors to have higher conviction that a rate cut is coming than the central bank itself has just now.”
Fed Chair Jerome Powell said in March that weaker Chinese and European economies are undermining U.S. growth.
“Now we see a situation where the European economy has slowed substantially and so has the Chinese economy, although the European economy more,” he said at the time. “Just as strong global growth was a tail wind, weaker global growth can be a headwind to our economy.”
That Powell and other Fed members have spent so much time in recent meeting discussing softer growth in Asia and Europe could mean that the central bank could step in and lower borrowing costs if it felt the U.S. economy needed a boost.
Still, many Wall Street insiders had assumed that the relative calm in U.S.-Chinese trade relations to start the year would soon lead to a permanent resolution. Instead, Trump’s weekend remarks that trade progress is moving “too slowly” caught many — including UBS Washington strategist Chris Krueger — by surprise.
Paying homage to the doomed British cavalry charge of the 1850s, Krueger poked fun at the renewed barbs between the two nations in a portion of his market warning entitled “The Charge of the Lighthizer Brigade.”
Prior to U.S. Trade Representative Robert Lighthizer’s Monday comments, Cowen had assumed the “‘Great Man’ theory would hold, Trump and Xi would have the best conversation, talks would continue, and Trump would put tariffs on hold for ~30 days,” Krueger wrote.
Lighthizer told reporters Monday that the planned tariff increased will take effect at 12:01 a.m. on Friday, but added that Chinese Vice Premier Liu He is expected to join a trade delegation in the United States this week.
“This was Trump acting out on a rainy Sunday in Washington with nothing on the public schedule,” he added. “To paraphrase Lenin: there are decades where nothing happens and there are weeks when decades happen…and then there is a single week in the Trump Presidency. What a time to be alive.”