Financial markets around the world have sold off sharply after Beijing signalled a readiness to strike back at Washington in their escalating trade war by restricting exports of rare-earth elements.

Wall Street recorded steep losses on Wednesday as the Dow Jones slumped to the lowest level in almost four months, losing about 221 points to trade at 25,126. The S&P 500 index also fell to a two-month low, sliding by 19 points to 2,783.

Against a backdrop of mounting concern over the long-running trade dispute between the US and China, which stands to choke global growth, Beijing signalled that exports of rare-earth elements to the US could be curtailed.

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Chinese media reports, including the People’s Daily, the flagship newspaper of the Communist party, raised the prospect of the crackdown, which would stand to hit American companies involved in electronics, car production and defence.

Quick guide What are rare-earth metals and what are they used for? Show Hide What are rare-earth metals? Rare earths refer to a group of 17 elements that are prized for their unique magnetic and electrochemical properties. They include elements such as cobalt, gadolinium, lanthanum, cerium and promethium, and are vital in the production of cancer treatment drugs, smartphones and renewable energy technologies. Where do they come from? They are not actually very rare and can be found across the Earth’s crust. However, they are often in low concentrations and are difficult and expensive to mine. The process can also damage the environment, with ecosystems put at risk by pit mining, the release of metal byproducts from refineries, and water contamination from particles being dumped during waste disposal. What are they used for? The use of rare earths is vast and varied, spanning national defence to consumer goods. They are used in healthcare, including for surgical supplies, pacemakers, cancer treatment drugs and rheumatoid arthritis medication. They are also found in telescope lenses, aircraft engines and are used as catalysts in auto exhaust systems to help reduce emissions. Neodymium is often used to produce high-powered, infrared lasers for national defence, while military suppliers such as BAE systems use rare earths to produce sensors for missile systems. Kalyeena Makortoff

Analysts said China handles roughly 80% of US imports of rare earths and that high-tech manufacturers could see their profits crippled by the measures.

Edward Moya, a senior market analyst at the financial trading platform Oanda, said: “It appears the financial markets are convinced the trade war is not going to yield anything promising any time soon, and new risks are emerging. If China does follow through on its rare export ban, the effect would cripple high-tech manufacturing.”

As the implications of the latest development in the trade war reverberated around the world on Wednesday, stock markets also fell sharply in Europe and Asia. In London, the FTSE 100 fell by more than 100 points to trade at about 7,168, while stock markets in Germany, Italy and France also slumped. Japan’s Topix index of leading company shares closed down by 0.9% and Hong Kong’s Hang Seng index dropped by 0.6%.

Pascal Blanqué, chief investment officer at Amundi, Europe’s largest fund manager with €1.45tn of assets under management, said there were still hopes that a deal could be reached between the US and China to avert a further crisis. “[However,] the threat of a trade war has returned, shaking investor confidence and awakening markets from complacency,” he said.

The veiled threat issued by China included a commentary in the People’s Daily that warned Donald Trump not to underestimate the country, which included language laden with historical significance.

The newspaper used the phrase “Don’t say we didn’t warn you!” in its editorial, in a development that observers said was rare and had been used by the paper in the run-up to the 1962 war with India and the war with Vietnam in 1979.

The escalation comes after the Trump administration raised the stakes in the long-running dispute by increasing US tariffs on $200bn of Chinese goods to 25% from 10% earlier this month. China is preparing to retaliate, with $60bn of tariffs on US imports due to take effect this weekend.

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Beijing has a disadvantage in the trade war because its exports to the US outweigh imports. According to the US Census Bureau, the US imported $539.5bn of imports from China last year, while exporting $120.3bn. While the White House has greater options for taxing imports, Beijing has alternative levers, including the sale of rare-earth minerals relied upon by US firms.

Economists at the consultancy Oxford Economics said the US tariffs would cut the country’s economic output by 0.3%, or $62bn, in 2020 relative to a situation where Trump had not ratcheted them up, while China stands to lose about 0.8% from GDP growth over the same period.

It also examined the controversy over who pays the cost of US tariffs, concluding that “US consumers are bearing most of the burden so far”. Trump has previously remarked that China is paying the tariffs, although the border taxes are paid by US importers of Chinese goods, driving up their cost.