As the U.S. economy continues to grow and the bull market in stocks charges on, investors apparently are underestimating the negative impacts that a trade war between the U.S. and China may unleash. This may be a big mistake, according to analysis by FactSet Research Systems. 

"In the case of the escalating trade tensions between the U.S. and China, while financial markets still appear to be discounting the global impact of a trade war, our analysis shows that if/when the market does react, the effects will be widespread," writes Ian Hissey, vice president in FactSet's portfolio analytics group, in a report quoted by CNBC. In FactSet's worst-case scenario, economic growth and stock prices would plunge worldwide, with U.S. stocks suffering a bear market decline of nearly 22%.

Stocks initially jumped in daily trading on Wednesday on news reports that the U.S. has reached out to China for a new round of trade talks before the Trump administration imposes new tariffs on Chinese goods. President Trump has vowed to smash what he sees as unfair China trade barriers. Both sides remain far apart on key issues.

Stocks Are Discounting The Risk of Trade War

Source: Yahoo Finance; gains computed through the open on September 12.

Analysis by UBS Group indicates that the growing trade war has reduced the gain for the S&P 500 Index by about 3 percentage points, Bloomberg reports. The impact on foreign stock indices has been even more pronounced, per UBS, which estimates that trade tensions have shaved about 11% off the Shanghai Composite Index and roughly 8% off the Stoxx 600 Index in Europe.

Lower Economic Growth and Stock Valuations

"Tariffs hurt the economies of both trading partners by creating inefficiencies and lowering economic growth," FactSet's Hissey writes, per CNBC, adding, "This would have a negative impact on equity market valuations." FactSet developed three scenarios: a base case with gradually increasing tariffs and trade restrictions between the U.S. and China; an optimistic case in which the two countries reach agreements that stop further conflict, but leave recent tariffs in place; and a pessimistic case in which tariffs and tensions escalate. Even under the optimistic case, U.S. stocks decline by nearly 11%, while stocks across the globe suffer a decline of more than 8%.

Flight to Quality

"In turn, sudden dramatic falls in equity valuations likely create a flight to quality assets.," Hissey continues in his report, per CNBC. Specifically, FactSet anticipates that the downturns in economic growth and stock prices spurred by continued trade restrictions, even under the optimistic case that represents a continuation of the status quo, will prompt investors to buy bonds. Average bond prices worldwide rise by 3.6% in the optimistic case, by 5.3% in the base case, and by 6.9% in the pessimistic case.

However, countries whose currencies tend to follow the U.S. dollar are projected to see declining bond prices according to FactSet's analysis, while the biggest bond market gains generally will be in countries whose currencies have the loosest ties to the dollar. Japan is projected to enjoy both stock market and bond market gains under all three scenarios.

Limited Consequences

A contrary viewpoint is offered by Andrew Kenningham, chief global economist at Capital Economics, MarketWatch reports. While acknowledging that certain industries are being hurt by a U.S.-China trade war, the London-based economist nonetheless believes that the aggregate economic impact on both countries will be relatively limited. Kenningham notes that both the U.S. and China are "fairly closed economies," with exports representing about 20% of China's GDP in 2017 and just over 10% of U.S. GDP.