- Rising trade tensions between the US and China could inject volatility into a vulnerable stock market, strategists and economists said Monday.
- The major US indices were under pressure on Monday after President Donald Trump threatened to impose new tariffs on Chinese goods by Friday.
- The major averages fell by as much as 2% on Monday morning before paring their losses.
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Investors grappling with the ongoing trade war between the world's two largest economies are dealing with a new headache.
On Friday, President Donald Trump told reporters that US-China trade negotiations were going "very well." But two days later, he threatened to implement fresh tariffs on hundreds of millions of dollars worth of Chinese goods.
Those threats slammed US stocks and financial markets around the world on Monday as strategists and economists up and down Wall Street expressed bewilderment and caution after Trump's abrupt U-turn took investors by surprise.
"What is not debatable is that markets were poorly prepared for this," Mandy Xu, an equity derivatives strategist at Credit Suisse, told clients in a morning report.
"If we do get a serious escalation, there could be further upside to volatility and a more sustained increase in the VIX as investors are not prepared for this," she later told Markets Insider by email on Monday.
Read more: Stocks are getting hammered after Trump threatens to slam new tariffs on hundreds of billions of dollars of Chinese goods
Xu was referring to the stock market's so-called fear index, or the Cboe Volatility Index, which indicates what kind of swings traders expect over the next 30 days. The VIX typically trades inversely to the S&P, implying a jump in the former would likely mean weakness in the latter.
Despite Monday's spike in volatility, investors haven't yet considered the probability of heightened US-China trade tensions, Xu said. Specifically, she noted that S&P 500 options were not reflecting any kind of event-risk premium for this Friday, when Trump threatened the new tariffs were set to kick in.
One could surmise from Xu's analysis that either the market doesn't think Trump will follow through with his threats, or that investors aren't properly positioned for what's to come.
The global sell-off on Monday suggested the latest trade-war escalation was a shock to investors, signaling markets could be in for a "bumpy ride before a trade deal is reached," Bank of America Merrill Lynch global economist Aditya Bhave wrote.
"Fasten your seatbelt and don't hold your breath" for a trade deal, he added.
Read more: Trump just turned up the heat in his trade battle with Beijing. There are 4 major implications for China.
Strategists say the S&P's 17.5% year-to-date gain through Friday had been fueled in part by the Fed's dovish positioning and the prospect that the US and China could reach a trade agreement. Both the S&P 500 and Nasdaq Composite rose to records last week.
As such, Monday's stock-market bloodbath was sparked by one of the very pillars of the impressive rally from the fourth-quarter's depths - investors holding out hope for a trade resolution.
"With optimism pushing the equity market close to our bull case, negative surprises like a potential re-escalation of trade tensions can have a greater price impact than fundamentals might dictate," Morgan Stanley equity strategists warned in a Monday report to clients.
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