The bulls on Wall Street are drastically underestimating both the short- and long-term risks to the stock market and broader economy stemming from an escalating trade war. Despite increased tariffs on imports from China and the threat of tariffs on Mexican goods, the S&P 500 has slipped barely 5% from its peak and is still selling at fairly rich valuations. But the stock market’s general strength amid growing head winds is looking increasingly untenable, according to a number of market analysts and strategists.

Even the sharp boost the market received on Tuesday as Federal Reserve Chair Jerome Powell hinted at lower interest rates to keep the economy steadily chugging along may not be enough to sustain the mounting downward pressures that increasing trade tensions are causing.

“The move down in markets over the past month is all about the trade war, but I don’t think this is fully in the price,” John Normand of JPMorgan Chase & Co. told Bloomberg. “The economic data were weakening before tariffs went up so we’ve yet to see the economic consequences of trade.” Five of those consequences to the raging trade war are noted below.

5 Consequences of an Escalated China-Mexico Trade War

  • Recession within 9 months;
  • S&P 500 earnings slowdown will accelerate;
  • Stocks could fall as much as 30% into bear market;
  • Severely disrupted trade relationships, supply chains longterm;
  • Downturn could accelerate unwinding of massive U.S. corporate debt.

Source: Morgan Stanley; JPMorgan Chase & Co., Citigroup, Bloomberg; Bank of America, Barron’s.

What It Means for Investors

Morgan Stanley chief economist Chetan Ahya, shares a similar view as Normand. “My recent conversations with investors have reinforced the sense that markets are underestimating the impact of trade tensions,” he wrote in a recent note. “Investors are generally of the view that the trade dispute could drag on for longer, but they appear to be overlooking its potential impact on the global macro outlook”

Ahya noted that if trade tensions continue to escalate to the point where the U.S. imposes 25% tariffs on the remaining $300 billion of imports from China, provoking further retaliation from the world’s second largest economy, then it is likely the U.S. could end up in a recession in three quarters, or nine months. JPMorgan Chase indicated that the probability of a recession before the year is done had risen to 40% from 25% a month ago.

The impact of additional tariffs on corporate earnings could also be severe. U.S. companies with revenue exposures to China and Mexico could see weakening demand, depressing revenues and earnings. Companies with cost exposures may not be able to fully pass on the cost of tariffs to consumers, resulting in shrinking profit margins

Strategists at both Bank of America and Citigroup cut their 2019 earnings-per-share (EPS) forecasts for the S&P 500 by $2 a share, and Bank of America estimated that the S&P 500 could take as much as a 30% hit if the White House imposes additional tariffs on the rest of Chinese goods.

The escalating trade war will also affect domestic and global supply chains, causing global trade flows to be redirected. Multinational companies will incur additional costs over the medium term as they restructure their supply chains and develop new sources of supply. Corporate confidence across the globe will be affected, which will weigh on global aggregate demand, according to Ahya. 

Looking Ahead

While the recent moves by the Trump administration have already pushed the trade war to heights that will put noticeable strains on the global economy, much uncertainty remains as to how long this negative pressure will last. Many are looking to the upcoming G20 summit as a location where the U.S. and China may be able to settle their differences.