While past trade tensions have had only temporary impact on markets, the latest round could have more serious implications.

The transition from July to August was a truly turbulent time for U.S. markets, with the S&P 500 falling 6% from July 30 to August 5 and the 10-year Treasury yield tumbling to 1.62%, the lowest level in nearly three years, on August 7. Although markets appear to have stabilized in the past few trading days, reasons for caution remain.

In particular, I’m concerned that the most recent U.S. escalation of trade and currency-related tensions with China could have more lasting impact on global markets than earlier scuffles. To any investors who are considering buying the dip, I would urge patience for a better opportunity.

I see three areas where the impact from continuing trade tensions has yet to be fully priced into markets, despite the recent downdrafts.

  • U.S. growth: Prior U.S. tariffs had limited economic impact due to offsetting currency moves and companies’ ability to fill gaps in their supply chains from other countries. This time, however, the impact of additional tariffs is unlikely to be offset by similar adjustments. That could mean higher prices for consumers or lower margins for corporations in critical sectors which thus far have been spared—including in the auto, electronics and tech sectors where stock valuations remain high. That prospect may further dent corporate confidence and capital investment. Morgan Stanley’s Business Conditions Index has returned to lows from earlier this year, reflecting these risks.

  • Currency shifts: The yuan has depreciated slightly against the dollar after the U.S. announced potential new tariffs. While that move might provide a buffer for Chinese manufacturers facing slowing sales, a weaker yuan could also unleash deflationary forces in the global economy as China is the world’s largest trading partner. Already this past week, fears of deflation have prompted global bond yields to fall to all-time lows as other central banks also moved to adopt easier monetary and fiscal policy. Should this dynamic of a stronger U.S. dollar and weaker emerging market currencies become uncontrolled, it could destabilize the global debt market, much of which is denominated in U.S. dollars. Despite recent stabilization, the risk of global markets coming unraveled remains.

  • Fed policy: The case for more Fed rate cuts has strengthened, amid slower economic growth and falling global interest rates. But trade dynamics could complicate the efficacy of further rate cuts. Indeed, the Fed could be “pushing on a string,” where lower rates and cheaper credit won’t be enough to boost economic growth. Equally concerning: Additional cuts this year could deplete the Fed’s options if a recession were to develop next year. 

Meantime, the risk of a U.S. recession, while not in our base forecast, is rising. Forward-looking economic indicators are deteriorating, and the inverted yield curve, an important indicator based on bond market dynamics, continues to point to a coming recession. U.S. markets are richly priced, and corporate and consumer confidence, which hold the key to the longevity of the economic cycle, could be poised to fade.

Rather than trusting that the Fed can keep the economy and markets aloft, my recommendation is that investors should stay broadly diversified and sit tight, while waiting for the summer smoke to clear.

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