How Trump's trade war is unraveling the Trump rally

Stocks plunged on Thursday after Apple (AAPL) blamed a big sales miss on slowing growth in China and rising trade tensions.

China's massive manufacturing sector, already under pressure before tariffs hit, has tumbled into contraction. And trade trouble helped fuel the biggest one-month decline in US factory activity since the Great Recession.

"We've reached the point where China and the US are both hurting," said David Kotok, co-founder and chief investment officer at investment firm Cumberland Associates.

President Donald Trump has in the past cheered the weak Chinese stock market as a sign that his trade war is working. But that's backfiring now. Apple's slowing iPhone sales and China's weakening factory activity only reinforce the slowdown fears at the heart of Wall Street's meltdown.

All of this adds to investor angst over Federal Reserve policy and a slowdown in earnings that sparked the worst December for US stocks since the Great Depression.

In other words, Trump's trade war is helping to further unravel the Trump rally.

'Everyone loses'

It was a predictable outcome. China is the world's second-largest economy. And it's the planet's biggest exporter of goods. Pain there was always going to cause trouble elsewhere. The world is too interconnected for it not to.

"No one wins in trade wars. Everyone loses," said Kotok.

Of course, the trade war is not the sole reason China is slowing. Beijing's crackdown on risky lending put the Chinese economy on a downward trajectory. Tariffs from Washington are piling on the pressure.

"The trade effects are exacerbating the situation," said Barry Bannister, head of institutional equity strategy at Stifel.

Investors were taken aback by the sharp deceleration in American factory activity revealed on Thursday. The ISM manufacturing index remains in expansionary territory in December, but it declined to two-year lows.

"Growth appears to have stopped," one executive from a computer and electronic products manufacturer told ISM. The exec said resources are focused on navigating "US tariff mitigation out of China."

Ian Shepherdson, chief economist at Pantheon Macroeconomics, expects the manufacturing pain in America to deepen.

"The story here is that the trade war, coupled with China's underlying slowdown, is wreaking havoc in both countries," Shepherdson told clients in a report on Thursday.

Apple not alone

Apple, already hurting from soft demand for its high-priced iPhones, said the trade uncertainty dented customer traffic in the company's retail stores in China.

"Trade tensions between the United States and China put additional pressure on their economy," Apple CEO Tim Cook told CNBC on Wednesday.

Apple shares plummeted 8% on Thursday, on track for their worst day in five years.

White House economic adviser Kevin Hassett seems to agree with Cook's assessment.

"Right now, China is feeling the blow really of our tariffs," Hassett told CNN's Poppy Harlow on Thursday, adding that the slowdown "might be called a recession."

Hassett warned that China's deepening slowdown will cause "a heck of a lot" of US companies with exposure to China to follow in Apple's footsteps by downgrading their outlooks.

Those are not exactly encouraging words for already-jittery investors.

Stifel's Bannister warned that recent history shows the S&P 500 doesn't typically bottom until China's manufacturing activity does.

A deal to avert disaster

The good news is that the market turmoil gives Trump a powerful incentive to find trade peace with China.

"Of course, the president is concerned about markets," Hassett told CNN.

He predicted that "when we settle the trade issues with China" investors will go back to focusing on long-term economic growth.

Trump and Chinese President Xi Jinping reached a tentative trade truce late last year. Talks are scheduled to try hammer out a comprehensive deal, or at least a face-saving measure that averts disaster.

If Trump fails to reach a deal with China, the economies and stock markets of both countries could continue to deteriorate. That is an outcome that neither Trump nor Xi want.

"Trump needs to make a deal because the 2020 campaign has started," Kotok said. "Trump doesn't get reelected with a lousy stock market and economy that has gone into a slowdown or recession."