New York CNN Business  — 

Tariff Man is back. And investors didn’t see him coming.

President Donald Trump blindsided Wall Street over the weekend by threatening to ramp up tariffs on China.

The sudden escalation of trade tensions punctures a period of historic calm and optimism in global markets.

Rather than a deepening trade war, investors had been betting on trade peace. Real progress on trade negotiations between Washington and Beijing helped propel Wall Street this year. But a trade deal is now in doubt, underscoring the unpredictability of investing in the Trump era.

“It was our belief that we were nearing the end of the end, though perhaps this is only the end of the beginning,” Chris Krueger, analyst at Cowen Washington Research Group, wrote in a note to clients.

World markets, led by China, plummeted on the news. US stocks opened sharply lower before rebounding to trade with just modest losses.

Rather than focusing on earnings and economic fundamentals, market analysts were left grasping at what caused the sudden reversal by Trump, who last year called himself “Tariff Man.”

“Something must have really pissed off Trump over the weekend,” Peter Boockvar, chief investment officer at Bleakley Advisory Group, wrote in a note. “Regardless, the global economy is in a fragile state that isn’t in a position to easily assume more tariff disruptions.”

Tariffs raise uncertainty

Trump on Sunday threatened to raise the 10% tariff on $200 billion worth of Chinese goods to 25%. And he suggested new tariffs of 25% on an additional $325 billion of US imports from China.

Tariffs raise costs on households and businesses and make it very difficult for companies to devise long-term plans.

At a minimum, the outbreak of tensions introduces a significant element of uncertainty into a market that had been pricing in very little.

The CNN Business Fear & Greed Index had been sitting comfortably in “greed” mode, but it shifted back to “neutral” on Monday. The VIX volatility index soared more than 20% to six-week highs.

“The market got skittish, very, very quickly,” said JJ Kinahan, chief market strategist at TD Ameritrade. “Everyone was a bit surprised. All the indications we had from the administration were that talks were going fairly well.”

Trade deal could still be in the cards

Boosted by easing trade tensions and the Federal Reserve’s sharp pivot, US markets soared to record highs last week. Despite Monday’s drop, the S&P 500 remains up 16% in 2019, while the Nasdaq has surged nearly 22%.

The bulls are hoping that Trump’s Sunday tweets are just a blip that won’t derail trade talks. They are betting Trump is just trying to raise the pressure on Beijing to prevent negotiators from backtracking on previous commitments. That thinking helps explain why stocks recovered from early morning selling Monday.

“The president’s history so far tends to be grandiose statements, followed by a more practical landing — but it takes a while to get there,” said Kinahan.

In that scenario, a trade deal could still be reached, perhaps even later this week.

Barclays economists on Monday maintained their base-case view that a trade deal will be reached. They said markets will watch closely whether Chinese Vice Premier Liu He joins the Chinese delegation scheduled to fly to Washington this week.

“We think both sides still want to strike a deal, as the stakes are higher now than last summer,” Barclays wrote in a note to clients.

‘Credible risk to markets’

In a worst-case scenario, Trump’s threats represent a new battle in a trade war between the world’s two largest economies.

Morgan Stanley warned that renewed trade tensions would wipe out 0.3 percentage points from China’s GDP. Asian and emerging markets could tumble 8% to 12%, the investment bank said. China’s Shanghai Composite plummeted nearly 6% overnight alone.

A reescalation of tariffs poses a “credible risk to markets,” Morgan Stanley strategist Michael Zezas wrote to clients.

Barclays said that a 25% tariff on $200 billion worth of Chinese goods had been its “worse case” scenario. Such a levy would hurt Chinese exports by 3% to 5% and wipe out up to 0.5 percentage points of China’s GDP.

An additional 25% tariff on $325 billion of US imports from China would reduce the country’s GDP by another 0.5 percentage points, Barclays warned.

Optimism probably released Tariff Man

Trump was likely emboldened by recent signs of strength from the US economy.

Defying slowdown fears, US GDP accelerated to 3.2% in the first quarter. The economy added a robust 263,000 jobs in April. And the unemployment rate dropped to 3.6%, the lowest since December 1969.

The stock market, meanwhile has raced back to life since suffering its worst December since the Great Depression.

“When the market hits all-time highs, Tariff Man is released from his lair,” Cowen’s Krueger wrote.

The good news is that market analysts don’t believe renewed trade tensions will last long. They are just too costly for both sides.

“Experience from last year shows that higher tariffs are costly for the US markets and Trump’s voter base, though more so for the Chinese markets and public sentiment,” Barclays wrote.

In other words, while trade fears may be driving markets lower on Monday, a prolonged market and economic slump would eventually drive Washington and Beijing to strike a deal.