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What Investors Should Know as the Trade War Escalates

Matthew Frankel, CFP, The Motley Fool

The trade war between the United States and China just jumped to the next level. Negotiations have yet to produce a deal, leading the Trump administration to increase tariffs and move to expand the number of imports with tariffs levied against them -- which prompted China to retaliate. In response to the escalating standoff, the stock market had a volatile start to the week, with the Dow Jones Industrial Average down more than 600 points on Monday, followed by a significant rebound on Tuesday morning.

When any economic situation causes this much market upheaval, it's important to take a step back, assess the situation, and understand exactly what we're dealing with. So, here's a quick rundown of the latest trade war developments and how investors would be wise to react.

Two fists, one painted as a Chinese flag, the other as an American flag.

Image source: Getty Images.

The latest developments in the trade war

Last week, the trade tensions ratcheted up significantly when President Trump tweeted that because of slow progress in trade negotiations, tariffs on $200 billion worth of imported Chinese goods would rise from 10% to 25% on May 10.

When trade negotiations toward the end of last week failed to produce a deal or any meaningful progress, the higher tariffs kicked in as planned. China responded by implementing 25% tariffs of its own on Monday, but on $60 billion worth of U.S. goods.

Then, the Trump administration began moving to place tariffs on all $540 billion of Chinese imports, representing a significant increase from the previous segment of goods that were subject to the tariffs.

Why are tariffs such a bad thing?

The tariffs are generally being sold to the American public as "money in the bank." In other words, 25% tariffs on $200 billion worth of goods means an additional $50 billion in the U.S. Treasury. That's a good thing, right?

Here's the problem: China doesn't actually pay the tariffs imposed by the U.S. And the U.S. doesn't pay the tariffs imposed by China. The businesses that import goods pay the tariffs. For example, if an electronics manufacturer wants to import $10 million worth of parts from China, and these parts are subject to a 25% tariff, it will cost this manufacturer $12.5 million instead.

When imports cost more, companies will still aim to make a profit. So they will pass the increased cost of the tariffs on to consumers. This could not only hurt the financial situation of U.S. households, but it could temper demand for certain products as costs increase. Basic economics says that when prices rise, demand falls, so companies could end up with lower revenue as a result.

The worst thing you can do

The absolute worst thing you can do in this (or any other) volatile situation is to panic and sell your stocks. It's human instinct when things get bad to get out "before it gets any worse." This instinct can serve you well in some areas of life, but investing isn't one of them. It doesn't matter if the market drops by 2,000 points and experts are forecasting another 25% downside. Selling because the market went down is a bad idea.

In short, we all know that the point of investing is to buy low and sell high, but panic-sellers are doing the exact opposite.

What smart investors can do

First and foremost, it's important to realize that this uncertainty doesn't change anything from a long-term standpoint. Over the years, the stock market has produced consistently strong returns over long time periods despite trade wars, actual wars, recessions, depressions, inflation spikes, and other adverse conditions.

Having said that, if the market continues to come under pressure from the trade war, it could be a good time to shop for bargains. Some fantastic companies that do a considerable amount of business in China have already been beaten down. Apple (NASDAQ: AAPL) is one such example -- the tech heavyweight assembles (and sells a lot of) iPhones in China, and the stock is down more than 11% so far in May.

To be clear, there are some companies (such as Apple) whose revenue could certainly be affected as the trade war plays out. However, from a long-term perspective, if the investment thesis hasn't changed -- just the price tag of the stock -- then that represents an opportunity.

Will the trade war be a good or bad thing long-term?

Obviously, it's in the best interest of consumers, as well as investors, for the U.S. and China to work out a fair trade deal. And, because China sells significantly more goods to the U.S. than the reverse, there's some degree of truth to the assertion that the U.S. has the upper hand in the negotiations.

Having said that, the talks are dragging out longer than anticipated, and the latest round of tariffs could certainly do significant economic damage if they are kept in place for a long time. Ultimately, the trade war will come to an end with a new trade deal, but when that will happen remains anyone's guess.

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Matthew Frankel, CFP owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.