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Market could shrug off this trade tussle with Europe because NAFTA and China are what really matter

Key Points
  • Stocks sold off on the Trump administration's plan to slap tariffs on steel and aluminum imports as of midnight.
  • But strategists say after the initial jolt, stocks could move higher since the tariffs are not broad enough to stall the economy or dent profits.
  • Strategists say, however, if the trade battle complicates the outcome for NAFTA or if China trade talks fail, all bets are off.
Employees stand next to the electric arc Furnace at Liberty Steel's Aldewerke mill in Rotherham, U.K.
Chris Ratcliffe | Bloomberg | Getty Images

The Trump administration's new tariffs on steel and aluminum imports could create more risk and market volatility, but stocks ultimately should shake off the latest trade skirmishes and head to new highs this year, barring a much broader escalation.

The Commerce Department on Thursday announced the U.S. would slap tariffs of 25 percent on steel from the European Union, Canada and Mexico and 10 percent on aluminum. Other trading partners, like Brazil, South Korea and Australia would instead face quotas on metals imports. Trade partners responded angrily. Canada announced retaliatory tariffs on steel and aluminum, and Mexico said it would put tariffs on U.S. products, like flat steel, pork bellies, grapes and cheese.

"What we've seen since mid-March is that trade and the announcement of headlines around the potential for China tariffs has really derailed the rally. I think what we've seen since the middle of April is that the trade headlines have had less impact on stocks, so seemingly investors are becoming less sensitive to some of the headlines," said Keith Parker, head of U.S. equity strategy at UBS. "This has been in the market for awhile. If you go back to mid-March the S&P was trading around mid 2,800. I do think some degree of uncertainty is priced in."

Parker said bigger risks for the stock market would be a spike in interest rates or a failure of the economy to grow as expected. Strategists also said the latest tariffs could have some economic impact, but are not big and broad enough to represent a trade war that would stall growth or put a big dent in profits.

"It's a volley," said Jack Ablin, CIO of Cresset Wealth Advisors. "To me, it's not enough to shift strategy." Ablin said he is slightly underweight U.S. large cap stocks, and is considering raising his now neutral weighting in small caps, a corner of the market that is less impacted by trade friction.

The S&P 500 closed down 0.7 percent, at 2,705, and the Dow fell 251 points to 24,415. The small-cap Russell was off 0.9 percent at 1,633. The dollar was lower, but Treasury yields remained higher. Steel stocks, like AK Steel, U.S. Steel and Nucor surged initially but gave up their biggest gains by midday.

The S&P is up about 1.2 percent year to date and is still more than 5.5 percent below its all-time high, reached in late January.

Stocks should be able to move ahead, but all bets are off if the U.S. engages in a bigger trade battle with China, or fails to reach a new deal to replace the North American Free Trade Agreement with Canada and Mexico.

Goldman Sachs economists said in a note that the tariffs on Canada and Mexico could make reaching a near-term NAFTA agreement more difficult.

Commerce Secretary Wilbur Ross told CNBC that the tariffs were placed on Canada and Mexico because talks did not go far enough with those nations to warrant another extension of the tariffs, first planned for March 1. They now go into effect at midnight Thursday.

"We might be stuck with these steel and aluminum tariffs, and [Trump's] showing he's serious about wanting to have some concessions. This does not mean he's committed to a trade war by any stretch, but it does show it's going to be more complicated to negotiate with him going forward from the perspective of the European Union and Mexico and Canada," said Paul Christopher, chief international investment strategist at Wells Fargo Investment Institute.

Christopher said he still expects a NAFTA deal, and also a U.S.-China trade deal. "They may not be right away, and there will be days when it looks worse that it does from the day before," he said. Christopher said he too favors U.S. small caps, and the developed markets of Asia, like Japan and Hong Kong.

"I doubt we will revert back to the selling we saw in March and April," he said.

Parker said the market has adjusted to the potential impact from trade skirmishes and it's likely been priced in, unless there's escalation. He said the interest rates are stabilizing this quarter and economic growth is improving, and stocks can continue to make gains.

"As long as we're not seeing signs that things are escalating and then we're having a breakdown of discussions and potential risks to long held relationships," said Parker.

Christopher said the tariffs do inject more uncertainty in the market, and that can lead to more volatility. "Now it's up to the Europeans, Mexicans and Canadians to simply capitulate or make some concession, and it's not clear what they do. NAFTA's prospects were already looking dimmer," he said.

Tariffs are not a new weapon, and the U.S. has many in place already. "It would not be consistent with the kind of negotiations presidents have done in recent decades. People immediately jumped on the idea of a trade war, but it's become more clear in the last two months that a trade war is a 40, or 60 percent tariff on a broad range of goods," he said.

Parker said in the first quarter, the market was spooked by how possible trade wars could impact the economy. "The market was grappling with how to price the risk...where you have a breakdown in relations has always been the key risk for me. Our downside scenario pretty much was that trade facilitates productivity growth. If you can't outsource or use other capital around the globe than growth becomes more difficult," he said.

"We estimate that 20 percent of productivity growth in the last cycle was due to trade. If you take that off, it's an important consideration," he said.