The biggest threat to markets from a trade war

Last week was a pretty tough one for global stock markets.

The big fear is a trade war between China and the US.

US president Donald Trump and Chinese president Xi Jinping apparently have a very close relationship. And you can certainly see a few common threads between them.

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But that's not going to stop them getting shirty with one another over trade.

Why a trade war would hurt everyone

Last week, the US proposed $50bn of tariffs on Chinese imports, which adds up to 25% tariffs on more than 1,300 items from flat-screen tellies to electronic parts.

The Chinese weren't chuffed. They countered with a list of $50bn of duties on US imports, including all-important soybeans (which will upset American farmers).

Not to be outdone, on Thursday, Trump asked US officials to find another $100bn. China again responded angrily.

Trump tweeted yesterday that "China will take down its trade barriers because it is the right thing to do. Taxes will become reciprocal and a deal will be made on intellectual property." But that seems for now like somewhat wishful thinking.

So for now, there's the risk that China and the US will be putting extra taxes on $150bn-worth of imports from each other.

You can have a good old back and forth about the rights and wrongs here. You can argue that China hasn't played fair on trade over the years. Nor has any other rising economic power in the history of humanity.

You can argue that the US is right to be annoyed and has the clout to make a difference. But unpicking a global system that has worked pretty well to raise large numbers of people out of poverty and provided us all with lots of "stuff" is a risky business.

You might get a good outcome a fairer but still open system. But you might get a trade war, and a more closed system, which is likely to leave everyone poorer.

We're always moaning about our consumer society, but I think most of us despite any monastic aspirations we might profess would miss the benefits generated by companies competing for our attention.

You might not mind having a smaller range of breakfast cereals to choose from, for example. But you might be a little less excited by the idea of your smartphone's features evolving more slowly, or your dream of a utopia filled with electric cars being stuffed by an inability to get parts or battery components from one end of the world to the other in a friction-free manner.

In some ways, markets react similarly to a trade war as to a real war

Anyway so what does it all mean for markets? Are investors right to be rattled?

It depends. The tricky thing about trade wars in terms of the market impact is the question of escalation. In fact, it's not entirely unlike the market reaction to an actual war.

People often say that markets hate uncertainty. That's clearly nonsense. Markets are a mechanism that exist expressly to help us cope with uncertainty. If we knew for sure what the future held, we wouldn't need markets.

Markets do, however, struggle with events that are hard to gather useful information on, that are somewhat open-ended, and that are subject to a lot of politicking and decisions being made that don't strictly prioritise economic outcomes.

In other words, markets aren't great at second-guessing human behaviour. And that's one reason why they struggle with events like this. When war breaks out or is on the verge of breaking out, it's scary and the range of potential outcomes seems very wide. That's hard to incorporate into prices in any reasonable manner.

It's typically not until the parameters of the problem become clearer that the market can get to work on incorporating the event and its ramifications into prices. So in the case of a physical war, it's perhaps when you move from the escalation phase and you have an idea of the scale of the conflict.

On the trade war side, it's similar. As Capital Economics notes, chances are that everyone will come to a deal and that this is a negotiating tactic. On the other hand, with Trump facing mid-term elections, maybe he reckons that playing the strong man standing up for US jobs, is a vote winner.

As a result, for now, we can't tell whether it'll balloon into something much more significant, or whether both sides will step back from the brink and discuss a deal that both sides can tolerate. Even if that's negative for certain sectors, the market would rapidly price that in and then calm down.

But until a line is drawn and the threat of escalation recedes, I'd expect the current wave of panic one day, relief the next to last for a while.

Again, the question of how much this matters to an individual investor is a separate issue. If you're sticking with relatively cheap markets and also maintaining a watchlist, so that you're ready to buy any stocks that you've had an eye on when they go on sale, then this sort of environment is really a more positive one than we've had for a while.

You don't really want markets to keep going up when you're a net buyer of stocks. You want Mr Market to be losing his head and running to you, begging to offload his quality stocks in return for your best offer. So if you haven't got a shopping list, start making one.