The U.S. and Canada reached a last-minute deal Sunday to revise the North American Free Trade Agreement, but trade disputes are likely to remain a key concern for the U.S. stock market, raising questions about how investors should position their portfolios to minimize any pain that could occur.

According to Goldman Sachs, there is a real risk that U.S. profit growth could stall or even reverse in the event the trade situation between the U.S. and China deteriorates, something it sees a high probability of. In such an environment, where equities lose one of the primary factors that have been boosting prices, the primary focus for stock pickers should be to look at margins, the investment bank wrote.

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“As the boost from tax reform fades, firms with the ability to maintain or expand profit margins will become increasingly scarce and will likely be rewarded by investors,” the firm wrote to clients. “Companies with high pricing power are well-positioned to pass through input cost pressure to consumers, preserving high margins.”

This is a trend that Goldman has already observed, as seen in the following chart, which shows strong outperformance by high-margin companies relative to ones that have either low or variable gross margins.

Courtesy Goldman Sachs

According to the investment bank’s data, a basket of companies with high and stable margins have risen 12% thus far this year, while a group of stocks with low and variable margins have dropped 6%. The S&P 500 SPX, +0.00% is up 9% in 2018.

On a sector level, Goldman Sachs wrote that the software and services industry could be the best positioned on the score. Not only have gross margins rose for the industry over the past two years — by 56 basis points — but it is seen as having a high degree of pricing power. On the other end of the scale, transportation stocks are seen as having low pricing power, and they have experienced a contraction in margins over the past two years.

Courtesy Goldman Sachs

Currently, net margin for S&P 500 companies is at a record high of 10.7%. However, this could come under pressure as 48% of firms reported rising material costs, according to the National Association of Business Economics Survey, while an additional 48% reported wage costs. Only 20% of companies reported that they were raising the prices they were charging to consumers to offset these factors.

“In the past, this dynamic has preceded declining S&P 500 EBIT margins,” Goldman wrote, referring to earnings before interest and taxes.

According to the investment bank, rising tariffs could have a pronounced impact on corporate profitability. It calculated that a 25% tariff on all imports from China — a scenario it assigned a 60% probability to — would lower 2019 earnings by 7%, which would mean no growth from 2018 levels. Such an outcome could result in the S&P 500 dropping 10% from current levels, it wrote.

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Beyond that, if “trade tensions spread significantly and a 10% tariff were implemented on all US imports, which would represent the highest rate since 1940s, our EPS estimate could fall by 15%.” (Emphasis in original.)

Courtesy Goldman Sachs