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China's Trade War Escalation Has Spooked Wall Street

The ongoing trade conflict between the United States and China has been marked by alternating bouts of fury and friendliness. Last week, fury took the upper hand with President Donald Trump's fresh threat to both increase existing punitive tariffs and set new ones on a range of Chinese goods. In response, Beijing took the radical step of allowing its currency, the yuan, to float more freely, resulting in a rapid slip in its value against the dollar on Monday.

China's latest move appears to have had the desired effect, throwing U.S. markets into turmoil and sparking immediate political backlash against the Trump administration's increasingly bellicose trade posture.

Now, even the experts are skittish about what may come next. Judging from the initial analysis coming out of top Wall Street firms, there is ample reason for investors to sweat.

Cowen: Turning the trade war up to 11

The U.S.-China trade war has entered a new, more aggressive phase, according to Cowen. In spite of the increased tension, analyst Chris Krueger still managed to summon a bit of levity in his otherwise grim assessment of the situation:


"Overnight, Chinese government retaliated against new U.S. tariffs, and it's designed to get the President's attention...On a scale of 1-10, it's an 11."



A bit of gallows humor can go a long way to salve the wounds resulting from bad news. But, alas, Krueger's channeling of Spinal Tap is not likely to turn many frowns upside down in this particularly fraught time.

In both economic and geopolitical terms, there are few things worse than the world's two largest economies ratcheting up destructive practices. According to Cowen, Beijing is willing to take drastic action to demonstrate publicly that it will not be cowed by the Trump administration. With a line in the sand now drawn, any move toward reconciliation will rely on both sides acting, or at least being seen as acting, from positions of strength.

Goldman: No deal until after the presidential election

Goldman Sachs (NYSE:GS) also published an analysis of the freshly confrontational trade postures being set in both Washington and Beijing. Jan Hatzius, the investment bank's chief economist, clearly had no time for jokes, instead offering a sobering outlook for the next year :


" Both sides in the trade conflict are taking a harder line, reducing the odds of a resolution in the near term...We no longer expect a trade deal before the 2020 election."



While Goldman had not been especially optimistic about the prospect of Trump and Xi Jinping, his Chinese counterpart, burying the hatchet, the bank's analysts had been moderately confident that a peaceful accommodation would eventually be reached.

With hopes of near-term detente now dashed, it seems Goldman now agrees with our recent assessment of the situation, namely, that Xi is willing to fight a short-term battle in the hope that a more conciliatory American president will hold office after the election in November 2020. With more than a year to the election, investors may find themselves in limbo for an uncomfortably long time.

Morgan Stanley: Global recession on the horizon

If Goldman's assessment of the U.S.-China conflict is pessimistic, then Morgan Stanley's (NYSE:MS) is downright apocalyptic. According to Chief Economist Chetan Ahya, the Trump administration is likely to respond to Beijing's intransigence with further escalation :


"We take [the Trump administration's] literal message of planned tariffs quite seriously. There's a pattern of responding to insufficient negotiation progress with escalation...As we view the risk of further escalation as high, the risks to the global outlook are decidedly skewed to the downside."



While his decision-making process may often appear chaotic or mercurial, a few observable patterns of behavior have emerged as a consequence of the iterated game of negotiations. When pushed, Trump pushes back.

Unfortunately, when pushing back involves retaliatory tariffs, it can result in far-reaching economic consequences. By Morgan Stanley's reckoning, an escalation of tit-for-tat tariffs in the months ahead could end up plunging the global economy into recession.

Verdict

Beijing has thrown down the gauntlet in a very public way, which means Trump will likely respond with his characteristic aggression. According to Morgan Stanley's latest report, investors should prepare accordingly:


"Investors should behave as if further escalation will happen in 2019."



Of course, preparing one's portfolio for potential calamity is easier said than done. But if Morgan Stanley is right, investors would be wise to make the effort sooner rather than later. According to the investment bank, a tariff hike on Chinese imports to the U.S. to 25% would be a sufficient catalyst to precipitate a global recession within nine months. In other words, if Goldman's conclusion that a trade deal is off the table until November 2020, then the global economy is in for a world of hurt.

Sentiment is already darkening, and there is limited prospect of a positive reversal in the near term. Investors should begin working to insulate themselves now.

Disclosure: No positions.

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This article first appeared on GuruFocus .