JPMORGAN: America's small businesses risk running out of money as the trade war rages on - and investors appear blind to the mounting pressure

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JPMORGAN: America's small businesses risk running out of money as the trade war rages on - and investors appear blind to the mounting pressure

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Alvin Baez/Reuters

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  • If the US-China trade war enters a more dangerous phase, small businesses are much more vulnerable than larger firms in terms of losing their cash flow, according to JPMorgan strategists.
  • However, investors are underestimating the risks of an escalated trade war to businesses both big and small.
  • JPMorgan unearthed the evidence for this complacency, and offered a trading recommendation to protect against an even deeper trade war.
  • Click here for more BI Prime stories.

There's little upside for investors if the trade war between the US and China continues to escalate.

JPMorgan's equity strategists have attempted to quantify the damage, and estimate that the S&P 500 would fall to around 2,550, or by 13% from current levels, if the US slaps tariffs on an additional $300 billion worth of Chinese goods.

But traders far and wide aren't making big bets that this scenario will unfold. In fact, to JPMorgan's quantitative and derivatives strategists, traders are underestimating the risks to businesses both big and small. And the singular risk they highlighted in a recent note to clients is that companies could lose their profits or run out of cash altogether.

Before diving into this risk, it's worth listing some of the dislocations between JPMorgan's vision of the trade war and what markets are pricing in.

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Overall, they found that investors with systematic strategies did not make major adjustments to their equity exposure in May, compared to what they did when volatility ensued last year.

Additionally, Commodity Trading Advisors (CTAs) tasked with trading futures contracts increased their exposure to stocks in May, which turned out to be the market's worst month of this year as the trade dispute intensified.

Read more: 'We're going to get rolled': Billionaire investor Stanley Druckenmiller breaks down why the US is headed for devastating losses to China in the trade and tech wars

These trends fly in the face of what may be a new and more dangerous phase of the trade war. And to JPMorgan's strategists, small businesses will be among the casualties.

They single out Square, not because of its size, but because it generates a third of its revenues from transactions, including those made at small businesses. In yet another sign that market positioning was relatively benign, options show that wagers on Square's implied volatility in the next three months are trading cheaply - in the 21st percentile since the company went public in November 2015.

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But Square is far from the only company that would be punished by the next phase of tariffs.

"Comparatively, small businesses typically have limited pricing power and lower margins, and are in constant need of liquidity," said Marko Kolanovic, JPMorgan's global head of macro quantitative and derivatives strategy, in a recent note to clients. "They are therefore more vulnerable to slowing household consumption and tightening credit standards, and thus have limited ability to mitigate the negative impacts of trade."

A JPMorgan Chase Institute study found that the median small business would last 27 days before running out of cash if its inflows stopped. In the restaurant business, it would take roughly two weeks.

Within the realm of big business, JPMorgans's analysts estimated the risks in terms of lost profits. In a "disaster scenario," Best Buy's profit would shrink 168% and swing the company to a loss, Dick's Sporting Goods' would shrink by 93%, Costco's by 54% and Target's by 48%, they estimated.

Given these risks, Kolanovic advises that investors add protection via the options market.

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"We recommend investors purchase SQ September 85c/65p/55p put spread collars (i.e., selling the call to fund the purchase of the put spread), for a net cost of $0.74, indicatively ($70.46 reference price)."

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