S&P Would Fall 7% In Worst-Case Trade War, Goldman Says (Don’t Ask About Any Second-Order ‘Nonlinearity’)

Let’s be clear: It is impossible to estimate the impact of an all-out trade war on US equity prices with any semblance of precision.

The problem, obviously, is that while you can quantify the first-order effects, there’s no way to know, ahead of time, how the interplay of souring sentiment, lackluster liquidity and selling by vol.-sensitive investors will pan out, should things go off the rails entirely.

That said, there’s no harm in trying, one supposes. In a note out just before midnight, Goldman takes a look at the “threat from the trade war to markets”.

First, the bank notes that their financial conditions index has tightened by some 25bp since Trump’s infamous May 5 tweets. The primary driver is the selloff in equities, offset only partially by declining Treasury yields. Here’s the breakdown:

(Goldman)

Goldman calls Trump’s May 5 tweets “the cleanest ‘out of the blue’ surprise of the trade war”, which is really saying something, because this president is a man who prides himself on “out of the blue” escalations, both with regard to foreign policy and domestic matters.

The bank essentially uses the expected change in tariff revenue and the projected impact on financial conditions to extrapolate the cross-asset reaction to various trade war scenarios, the first being a deal and a “staggered off-ramp” for the tariffs, the second being an additional escalation in which the US moves ahead with duties on the remainder of Chinese imports and a worst-case scenario which piles auto tariffs on top of things.

“Under a deal, we estimate a 20bp FCI easing, with a 4% increase in the stock market and a 10-15bp increase in Treasury yields [but] a further escalation resulting in tariffs on all remaining imports from China would lead to a 25bp FCI tightening, with a 4% additional decline in the stock market and a 15bp decline in yields”, Goldman says, before warning that “if auto tariffs were imposed as well, we estimate a 40bp FCI tightening, with a 7% decline in the stock market, a 20-25bp decline in yields, and 1-2% appreciation in the dollar.”

(Goldman)

With all due respect – and while recognizing that if one isn’t willing to take the time to construct a better model, it makes little sense to question someone else’s – the notion that US equities would only fall an additional 7% in the event Trump goes “all-in” on China and eventually goes full- “Tariff Man” on autos, seems optimistic, at best.

To be fair, the bank has penned dozens upon dozens of notes documenting spillovers and attempting to quantify second-order effects, so this is more “straightforward FCI impulse assessment” than it is “sweeping effort to game out doomsday.”

Goldman acknowledges as much. “We see the risks as skewed toward larger market impacts in the escalation cases, if non-tariff measures are implemented as well or if sentiment deteriorates nonlinearly”, the bank says.

Indeed.