Seemingly frustrated by the pace of the U.S.-China trade negotiations, President Donald Trump said he will slap a 10 percent tariff on the remaining $300B of U.S. imports from China starting Sept. 1, and threatened he could raise the rate to 25 percent.

China hit back by targeting two areas important for the U.S. administration: it suspended agriculture purchases from the U.S. and let therenminbi/dollar exchange rate weaken through seven for the first time in a decade, perhaps calculating that given the poor prospects of a trade deal with the U.S., supporting the Chinese economy through a weaker currency was worth the risk of a presidential backlash.

In a largely symbolic gesture of retaliation, the U.S. Treasury Department then designated China as a “currency manipulator” for the first time in 25 years.

Bite vs. bark?

The tit-for-tat action rapidly escalated the dispute, rattling financial markets around the globe. But we believe the escalation’s bark is likely to prove worse than its bite.

For the U.S. economy, the impact of the new tariffs might be imperceptible, the equivalent of 0.1 percent of GDP, according to Tom Porcelli, chief U.S. economist at RBC Capital Markets, LLC. But pockets of the economy could be more affected than this number may suggest, as this final round of tariffs will hit products that the U.S. does not produce. The new tariffs are therefore a tax on U.S. businesses and consumers.

If the 10 percent tariff is indeed implemented on Sept. 1, the Chinese economy could lose more momentum, though the authorities have levers to pull to mitigate the pain. We would expect more fiscal stimulus, in addition to letting the yuan depreciate to offset some of the impact from additional U.S. tariffs—a strategy deployed by China in the past.

Further currency depreciation is possible over the next few quarters, but in a tightly controlled fashion by the People’s Bank of China (PBoC) so as to avoid a repeat of the 2015–16 episode that led to a destabilizing surge in capital outflows. Moreover, the authorities would not see a significantly weaker currency as desirable, as it would fuel inflation, making life more difficult for the central bank. This was confirmed by PBoC Governor by Yi Gang, who reiterated on Aug. 5 that China would not use the renminbi to deal with “external disturbances such as trade disputes.” Indeed, the PBoC set a stronger daily reference rate than the market expected on Aug. 6, stemming further weakness for now.

Flare-up, then plateau?

Following this spike in trade tensions, we would expect the situation to stabilize as both sides consider the stakes. After all, even if the impact of the trade war on both economies is manageable, it does crimp growth prospects as companies postpone capital spending until there is more clarity. Moreover, the stock market volatility was a clear message to the White House that an escalation could endanger one of Trump’s favorite scorecards, stock market performance.

Both China and the U.S. must realize they have much to lose, in our view. According to a report from the International Monetary Fund in May, should 25 percent tariffs be levied on all Chinese imports, the hit to U.S. GDP would be between 0.3 percent and 0.6 percent, and between 0.5 percent and 1.5 percent to Chinese GDP. Therefore, we continue to expect that cooler heads will prevail.

A laundry list of concerns

Markets are worried the trade dispute could push the global economy into a recession. Sovereign bond markets made that clear on Aug. 7 after three central banks cut interest rates more than expected (the Reserve Bank of India, the Reserve Bank of New Zealand, and the Bank of Thailand) and after German industrial production fell 1.9 percent q/q in Q2, suggesting the German economy may have contracted in the quarter. Long-term sovereign bond yields have come under severe pressure, as investors sought safe-haven assets. Among the G10 countries, only the U.S. and Italy now offer a long-term bond yield of more than two percent, though the 30-year U.S. Treasury bond yield is flirting with its July 2016 all-time low of 2.09 percent.

Moreover, the corporate earnings season has been lackluster and guidance is cautious. In the U.S. so far, S&P 500 earnings have grown around 2.7 percent y/y—meager growth but it’s coming against a very strong 2018. Meanwhile, earnings in Europe/U.K. and Japan have contracted one percent and eight percent y/y, respectively. In all regions, defensive sectors have posted positive growth, while most cyclicals have seen growth contract. Consensus estimates are taking the difficult environment into account, with 2019 projections revised down in all regions; 2020 estimates do not seem to have been adjusted yet but will likely have to be downgraded, in our view.

Beyond the trade war, investors have to contend with other geopolitical noise, with the U.S.-Iran standoff likely to escalate, as well as the possibility of a “no-deal” Brexit—while not a global event by any means, this could nevertheless destabilize both the UK and European economies at a time when both are slowing.

Pullbacks of four percent–10 percent for the S&P 500 were common in 2010, 2011, and 2016. Given that the S&P 500 gained more than 20 percent in the first seven months of the year, the close to seven percent correction from the July peak seems to fit this trend, in our view.

Hang in there

These are all valid concerns, and a defensive bias is warranted. With the 10-year U.S. Treasury bond yield falling, the yield curve is inverting further, an important warning sign that a recession could arrive in 9–12 months. However, our other recession indicators have yet to flash yellow. Employment data and leading economic indicators are still signaling that GDP should grow for at least another year.

As long as a U.S. recession does not appear to be imminent, we believe it is too early to become overtly risk averse, given equity valuations have fallen back to more attractive levels after the correction since the July peak. It is time, however, to be increasingly vigilant.