US President Donald Trump (left) and China's leader Xi Jinping have had many differences. Photos: AFP

It wasn’t just that US equities swung from rally to rout Thursday after President Donald Trump tweeted an additional 10% tariff on $300 billion of Chinese imports. Economically-sensitive assets were the biggest losers, a warning that the continuing trade war will do broad economic damage. Citibank had fallen by nearly 5% as of 2:30 pm, and the S&P bank index was down by 3.5%. Banks have little direct exposure to China, but the market fears that a deteriorating economy will damage bank earnings. Crude oil had its worst day since the price crash of 2015, down 8%.

The Dow Jones Industrial Average lost 333 points Wednesday after a Fed rate cut. Bond yields rose because the Federal Reserve chairman intimated that he didn’t have a plan for many rate cuts to follow. Until lunchtime, the DJIA retraced most of its Wednesday loss as bond yields fell, largely in response to unexpectedly weak purchasing managers’ report for manufacturing from the National Association of Purchasing Managers and Markit, respectively. Investors calculated that a weak economy would prompt the Fed to ease further, sustaining the cycle of cheap credit, higher leverage, high dividends and aggressive equity buybacks.

The ebullient mood lasted slightly after 12 pm, when Trump tweeted that he would impose a 10% tariff on Chinese goods not yet subject to tariffs, to punish China for failing to buy US agricultural goods, as the president had expected. At that point bond yields crashed along with stocks. Equity investors don’t mind a mediocre economy, or even mediocre profits. On a GDP basis, US profits have been falling since 2014.

But the prospect of an actual recession terrifies investors, who have rewarded companies for levering up their balance sheets to the highest gearing in US history. If growth falls below some hard-to-specify threshold, credit will dry up in the leveraged loan and high-yield bond markets, and highly-levered corporations will struggle to pay their coupons.

The trade war raises the prospect of an actual recession, and that explains this 600-point turnaround in the DJIA.

Why the president chose this particular Thursday afternoon to impose a new round of tariffs is unclear. Perhaps Trump believed that China had agreed to a quid pro quo, according to which the US would allow sales of components to the Chinese telecom giant Huawei, and China would buy a meaningful amount of US farm products.

Trump complained in his tweet that China had not taken any steps towards additional agricultural purchases (and also complained that China had not banned the export of fentanyl to the US). The president may have responded to Democratic attacks on his trade policy during the presidential candidates’ debates. It is also possible that China has provoked the president deliberately, hoping that economic fallout from the trade war would undermine Trump’s prospects for re-election.

All of this is conjecture. What we know is that equity market valuations buoyed by leverage applied to mediocre profits are very tippy.

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