We’re heading ever closer to all-out trade war

The Chinese stockmarket took a hit today.

The Shanghai Composite Index ended the session down 3.8% to close at a two-year low, notes Bloomberg.

What's wrong?

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Investors are starting to worry that Donald Trump is deadly serious about his enthusiasm for a trade war, that's what's wrong.

Trump has a point on China, although that doesn't mean this is a good idea

On Friday, Donald Trump released a list of $50bn-worth of Chinese goods that will face a 25% import tariff, with the aim of recouping "the annual cost of China's state-backed theft of US intellectual property", reports the FT. China retaliated by saying that it would impose tariffs on $50bn-worth of US products.

So, last night, Trump said that he had asked US trade officials to find another $200bn-worth that will earn a 10% tariff. These tariffs, he said, will go ahead unless China ditches its retaliation plans.

China didn't react too cheerfully. It denounced the US as acting "irrationally" and warned of "strong, powerful countermeasures".

It's admittedly harder for China to retaliate by imposing more tariffs, as it only imported $130bn of goods from the US last year. However, as the FT points out, it has plenty of other options. For example, it could "make life harder" for the likes of Ford and GM, "for whom China is their largest market." All the other US companies operating in China could be in the firing line too.

Investors are realising that Trump is quite serious about reducing the US trade deficit with China. And unlike on Europe where tariffs and trade barriers are broadly the same on both sides of the relationship Trump has a point on China. As Raoul Leering of ING points out, on average, China's tariffs on US imports are a good bit higher than America's tariffs on imports from China.

Moreover, US demand for Chinese products "contributes five times as much to their GDP as their demand for US products adds to US GDP". So, on a narrow level at least, this is a trade war that the US can, if not "win", at least come away better off than its rival.

That's not to say that this is an economically ideal solution. China is a big market and a lot of companies in the US won't be happy about the idea of being effectively shut out of it. Indeed, plenty of business leaders are already protesting. But if the political rationale adds up and so far it seems to, what with China having long been a source of concern and anger for a large group of American voters then Trump won't be bothered about the economics of it.

Here's what this could mean for investors

Anyway, what does this mean for markets? Trade wars aren't good. Companies ultimately make money by selling stuff whether physical goods or intangible services to customers. Trade wars cut down on the number of potential customers out there.

Protectionism also means that companies have a smaller global pool of labour to choose from. That means higher wages, all else being equal. So it drives up costs too.

On the other hand, it means less competition for domestic companies. That means companies can also afford to raise prices. Given where we are in the economic cycle (we're at or near the inflationary part), then that wouldn't come as much of a surprise right now.

So you can certainly see why Chinese stocks have been hit hard. If they can't sell to American consumers, then a lot of Chinese companies will be in trouble.

But emerging markets in general are hurting, both the stocks and their currencies. This is as much about "risk off" as anything else. The trouble with emerging markets is that investors are not particularly discriminating. You invest in emerging markets when you feel excited and positive about the outlook. When hard times hit, you pull the money back out and stash it at home.

Of course, if globalisation dries up, then that'll end up keeping more capital onshore too, so that's another issue facing emerging markets.

On the developed market side of things, German stocks are likely to be particularly hard hit the domestic picture in Germany is being blamed for the recent decline in the Dax, but to be honest, it's more likely because the German index is probably the biggest "sell" in the developed world if "de-globablisation" continues like this.

I wrote about Trump's trade wars in the latest issue of MoneyWeek magazine, which is out just now there are more tips in there. If you're not already a subscriber, get yourself a copy here now.

As for the trade war, is this going to continue to escalate? It all depends on what the participants do. It's pretty clear that Trump has no intention of backing down. A trade war would hurt both economies, but on balance, it'd probably hurt China more. On the other hand, a trade war is unlikely to be good for the US stockmarket, and US voters dislike falling stockmarkets.

On balance, I suspect the political calculus favours Trump continuing to take a strong stand ahead of the mid-term elections in November. But a significant concession by China might change his mind.

As for China it won't like the idea of being cut off from the US market, but nor will it like the idea of losing face. Put simply, this could go either way. So make sure you're hanging on to a bit of gold as well.