Stocks will sink if the US-China trade war gets even worse

Markets haven't sustained huge losses, so far

By Julia Horowitz, CNN Business

(CNN) - The trade war between the United States and China is back on. So far, markets haven't sustained huge losses. That will change if tensions continue to escalate.

With higher tariffs coming into effect, the next risk analysts see is a complete breakdown in negotiations between Washington and Beijing.

"If the deal totally falls apart, we think there's a pretty big chance of a market correction," said Ryan Detrick, senior market strategist at LPL Financial. US stocks could fall as much as 5% over the next month, he added.

Stock market declines are likely to be more pronounced outside the United States, where trade is even more crucial to the business environment and sustained growth.

An 'important moment'

Markets have whipsawed this week as investors tried to figure out whether President Donald Trump would follow through on his threat to hit China with higher tariffs.

The VIX, a market index that tracks volatility, shot up to its highest level since January.

On Friday, investors got their answer. The Trump administration hiked tariffs on $200 billion worth of Chinese imports from 10% to 25%, pushing the trade fight into a phase of renewed hostility.

China has promised that it will strike back without saying when or how. Retaliation from Beijing, followed by another round of tariffs from the United States, would be the worst-case scenario for markets.

"We're at a pretty important moment here," Detrick said. "Things could turn south very quickly if the trade dispute continues to spiral the wrong way."

US stocks, which set new record highs last week, have been cushioned by the Federal Reserve's decision to hold off hiking interest rates, as well as signs that the global economy has avoided a sharp slowdown.

Perhaps more importantly, China and the United States are still talking. Trade negotiations are expected to continue Friday in Washington.

Kit Juckes, a strategist at Société Générale, warned that a halt to those discussions would cause economic growth to slow and market volatility to "spread and worsen."

Investors are now preparing for the possibility that Trump follows through on a threat made last weekend to impose a 25% tariff on almost everything else the United States imports from China.

Mark Haefele, chief investment officer at UBS, told clients in a note this week that while the Swiss bank still expects a deal to eventually be struck, the potential for volatility had forced it to adjust its portfolio.

Top companies are likely to be caught in the crosshairs.

Apple helped trigger a market selloff earlier this year when it warned investors that the trade war hurt demand for iPhones in China. Boeing, which is already under pressure over the safety of its 737 Max planes, would be in trouble if China were to stop buying its planes. Harley-Davidson has already said that tariffs in the United States, China and Europe would cost the company up to $120 million this year.

"We need some kind of resolution of the China-US trade agreement for companies to know how to invest," Detrick said.

Global market trouble

A full blown trade war would be felt across global markets.

In Europe, Germany is particularly exposed because its industrial output is closely tied to Chinese demand. The country's carmakers have plants in the United States and do big business in China.

The DAX has rallied more than 14% this year in Frankfurt after a difficult second half of 2018. Those gains could be in jeopardy in China's nascent recovery falters.

The pain would be especially pronounced in China, where government stimulus efforts have propped up growth and boosted stocks.

"For China in particular, the higher tariffs will have a significant negative effect on exports, against the backdrop of a slowing economy," Michael Taylor, managing director of credit strategy at Moody's Investors Service, said Friday.

This could once again send the country's stocks into a downward spiral.

Trade tensions and a crackdown on risky lending helped push the Shanghai Composite down by almost 25% in 2018. The tech-heavy Shenzhen Composite shed 34% over the same period.

Before this week, the Shanghai Composite had rebounded to June 2018 levels.

Another dramatic decline in Chinese stocks would be reflected across emerging markets, especially in Asia, said Peter Boockvar, chief investment officer at Bleakley Advisory Group.

"As China goes, so goes that entire region," Boockvar said. "You can't have the two biggest economies fighting without an impact on global growth."

Plus, there's a good chance tariffs won't be eliminated entirely, even if the United States and China do come to terms soon, said Adam Slater, lead economist at Oxford Economics. That would keep weighing on markets.

The fraught state of the relationship between Washington and Beijing — now top of mind for investors — will also continue to loom large.

"I think it's unlikely we're going to go back to the status quo, no matter what happens here," Slater said.

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