Trade wars are a stupid idea, but it seems we’re going to have one anyway

The US and China are slapping tariffs on each other's exports

Unlike markets, I'm in a good mood this morning. We're working on a project here at MoneyWeek Towers which I know you'll be very interested in. I had a big meeting on the subject yesterday, and while I can't go into more detail right now, I'm aiming to have more to tell you later in the week keep an eye on this space...

Anyway, getting back to today's Money Morning as I said, markets aren't feeling quite as cheery.

Stocks were hit hard yesterday (as in, they fell by a couple of percentage points, which in this environment, counts as scary stuff) as the trade war between China and America continued to escalate.

So what does all of this mean for your money?

Markets are becoming ever-so-slightly less complacent

Here's the story so far. Last week, China and the US looked as though they were about to agree a deal on trade. Tariffs would be reversed or at least put on hold.

But then US president Donald Trump said that China had gone back on its original agreement, and that he would increase tariffs on Chinese goods from Friday. Friday came and went and the tariffs went up from 10% to 25%.

Now China has said that from 1 June, it will impose tariffs of up to 25% on $60bn-worth of annual US exports to China. And Trump has said that the US will impose tariffs on another $300bn of imports from China within a month.

So the two sides have gone from kissing and making up to throwing down the gauntlet and demanding that honour be restored.

Meanwhile, markets slid hard. Did they slide because of the trade war? It's always tricky to pin these things down, but on balance, I'd argue that they did.

Certainly, US stocks are overvalued (as they have been for years), but when you look at the ones bearing the brunt of the pain Apple, Caterpillar it's the big multinationals who are dependent on China both for making their products and for buying them.

Oh, and for a bit of comic relief, Uber (or "Unter", as we're starting to call it round these parts) also continued to slide. Just wanted to throw that in there.

We interrupt this bulletin for a brief defence of free markets

A quick point here, just to go back to first principles for a moment whatever your view of the rights and wrongs of this trade war, tariffs are a bad thing. Tariffs are just taxes. Like all taxes on companies, consumers end up paying them in the form of higher prices, and workers end up paying them in the form of lower wages or loss of employment.

Certain groups benefit at the expense of others, of course. Redistribution always creates winners as well as losers. But it's a zero-sum game. And it's capricious.

The nice thing about free markets is that there's usually a logic and a set of rules to the distribution of resources, even if it goes awry sometimes. When the government is doing the distribution, there's no logic there's just favouritism and lobbying. That's not conducive to nurturing an entrepreneurial economy.

Of course, one reason we're in our current situation is because crony capitalism, corporatism, and distorted incentives (partly down to our ongoing reliance on central banks to prop asset prices up) are firmly entrenched. We're so steeped in appalling economic ideas and cronyism that wading deeper into the swamp seems easier than going back.

So tariffs are in many ways simply the next logical step on the road to hell. But that doesn't mean that we should take it.

Anyway, just wanted to put that wee reminder in there that things like free markets are good and worth defending, even if we're a million miles away from that world now.

A reminder of the value of diversification

So what now? A few things for investors like ourselves to consider.

Firstly, this is a reminder of why we always need to question the conventional wisdom. On this occasion, I've been a bit guilty of failing to do this myself. The received wisdom was that Trump needed a deal and so did Chinese president Xi Jinping. Trump doesn't need the headache of a falling S&P 500. Xi doesn't need the headache of a slowing Chinese economy.

But there's more than one way to win political support. Neither of these guys is a shrinking violet. And picking a fight with an unpopular outsider is a good method of getting people behind you. Does Trump's base really care that much about the S&P 500? Part of the pro-Trump vote was a rebellion against Wall Street, after all.

It doesn't help that first-quarter growth in the US was much stronger than expected. That probably gave Trump more confidence to pull the plug on the deal. Meanwhile, China is also perking up, which would have helped Xi to feel happier about responding in kind.

So that's a valuable reminder the consensus is not always wrong by any means, but the odds that the market places on the consensus scenario actually happening are often too high, which leads to over-reactions when it doesn't happen.

Secondly, this is why we diversify. Stocks fell yesterday. But gold shot up, along with anything else that's viewed as a "safe haven". Oh, and it looks as though bitcoin is still a good bet on capital flight from China. The cryptocurrency which crashed last year and then spent a long time in hibernation has sprung to life in a dramatic fashion. (Not saying you should necessarily own a lot or any of it but it continues to intrigue me.)

Thirdly, I suspect that monetary policy still trumps trade tariffs. If markets continue to fall, the Federal Reserve America's central bank will have more and more licence to cut interest rates. And if China is in the middle of a trade war, then it also has a reason to keep stimulating the economy.

So it wouldn't surprise me if we start moving into a "bad news is good news" environment. Once the talk de-escalates again, then as soon as the Fed starts to hint at looser policy, markets could well rebound.

Of course, over the longer run, tariffs are inflationary, which will make it trickier for the Fed to do anything. But markets won't start to worry about that until the reality is jumping up and down and screaming in front of them.

One thing to keep a close eye on is the renminbi. We'll return to that topic another day as there's not the time to do it justice today, but if China decided to devalue, that would be a real "nuclear option" (as opposed to all the talk of selling US Treasuries, which would be self-destructive).