President Trump and China's President Xi Jinping pose for a photo ahead of their bilateral meeting during the G-20 leaders summit in Osaka, Japan, on June 29, 2019. (Kevin Lamarque/Reuters)

The world’s two largest economies are now in a full blown trade — and currency — war, and the dire warnings are piling up. The stock market had its worst day of the year on Monday. The bond market is signaling a coming recession. And prominent voices are calling this a dangerous moment.

“We may well be at the most dangerous financial moment since the 2009 Financial Crisis with current developments between the U.S. and China,” tweeted Larry Summers, the U.S. treasury secretary under President Bill Clinton.

Allen Sinai, a noted forecaster and chief economist at Decision Economics, told my colleague Jeff Stein: “This is a big policy mistake. We get recession because of policy mistakes like this.”

Even some Republicans are breaking ranks to express concern. “The tariffs placed on Chinese goods are now starting to bite into U.S. economic growth and prosperity,” Hank Paulson, the treasury secretary under President George W. Bush, said in a statement.

So how concerned should you be? President Trump’s trade war has been underway since January 2018. What’s different in the past week is that there is now no end in sight to this fight, especially between the United States and China.

The hopeful narrative that many on Wall Street had this spring — that Trump and Chinese President Xi Jinping would sign a deal soon — is gone. Trump pushed more tariffs, and China has shown it is willing to punch back. The consensus view now is: It’s going to get worse before it gets better.

As this conflict escalates, it is likely to weigh more and more on the stock market and the economy. After a rough few days, the stock market is back at the same level it was in January 2018 (i.e., the level before Trump put his first tariff on washing machines and solar panels). That’s a pretty clear signal from Wall Street that investors think tariffs have wiped out some of the benefits of the tax cuts and are dragging down prospects for future growth.

Is a recession coming? Experts were predicting the U.S. economy would grow 2 to 2.5 percent this year — a good but not spectacular pace. Most of this growth is coming from consumer spending. The key question is whether the trade war is going to dampen consumer spending. Businesses have already pulled back on their spending.

Will consumers follow? That’s the big unknown.

Trump is taking a gamble if he does end up putting 10 percent tariffs on $300 billion more of Chinese imports in September. This time around, the tariffs are mostly hitting popular items including laptops, iPhones, shoes and baby products, such as strollers. And these taxes are hitting just before the peak holiday shopping season.

So far, consumers remain pretty optimistic, according to closely watched surveys from the University of Michigan and the Conference Board, but that can change quickly. Remember December, when the market sank and came extremely close to entering bear market territory? That plus the government shutdown sent consumer sentiment (and spending) down for a few weeks. Now Trump is taking another risk — and he’s doing it at a time when the U.S. economy is slowing, making the stakes higher than a year ago.

Why is this happening? The headlines this week are about a “currency war.” China had been propping up its currency in recent years to keep it trading at a stronger pace than 7 yuan to the dollar. On Monday, China allowed the yuan to weaken to its lowest level in more than a decade. From a numbers perspective, it wasn’t that dramatic. The yuan traded at 7.0391 to the dollar vs. about 6.9 the day before. But from a symbolism perspective, it was huge.

China was signaling to Trump that it is ready to fight and will utilize all the tools of a centrally planned economy to do so. The United States fired back by labeling China a “currency manipulator,” something that hasn’t been done since 1994 but that Trump promised on the campaign trail to do.

The move from Trump is mostly symbolic. Under U.S. law, labeling a country a currency manipulator means the two nations are supposed to talk about it for at least a year. After that, the United States can take countermeasures, but they are pretty weak. China has already parried by stabilizing its currency Tuesday at a level just shy of 7 (6.9683 to be exact), a signal that Chinese leaders think they have made their point, at least for now.

There’s a chance Trump might attempt to devalue the U.S. dollar, but the reality is the United States has a lot fewer reserves than China to play these kinds of currency games on a large scale. The cheaper yuan also helps Trump because it mutes the impact of his tariffs. Laptops and shoes from China won’t be 10 percent more expensive this holiday season if China keeps its currency low.

The bigger blow from the Chinese was a statement that they will halt agricultural purchases from the United States, which will cause immediate pain for farmers who are already hurting.

What’s next? There are three things to watch from here. First, what does Trump tweet? He started off Tuesday by praising the U.S. economy, tame tweets that helped calm Wall Street down. Second, do U.S. and Chinese negotiators talk or meet in the coming weeks? They are supposed to meet in September. If that gets scrapped, it’s not a good sign.

Finally, keep a close eye on signs that companies are stopping their hiring or consumers are getting spooked. The U.S. economy is already cooling (to about a 2 percent growth pace this year vs. 2.9 percent last year). If companies stop hiring, it’s likely to cause consumers (and investors) to think this record-breaking expansion is about to end. That moment isn’t here yet, but Trump is risking it in the months before a critical reelection.

Related:

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