Yes, in the near term, but longer term we expect trade, tech, and possibly finances to decouple further. The “Phase One” trade agreement provides a much-needed truce in the tariff escalation between the United States and China, as trade uncertainty has weighed on financial conditions and further slowed global trade. While some progress has been made, structural disagreements run deep on critical topics, such as intellectual property protections and technology transfer requirements for market access, suggesting that this truce is vulnerable. As long as US negotiators view tariffs as leverage to influence these outstanding issues, further tariff escalation remains a risk. Markets have rallied hard on the news of an agreement, and we expect trade-inspired volatility to continue.
Tariffs have pushed up the cost of producing US-sold goods in China, leaving companies to revisit China’s appeal as a production center. Even before the trade war escalated, higher Chinese labor costs had already enticed some manufacturers to move production to Vietnam and other low-cost producers. There are limits to these shifts, however: No one country can replace China’s quality and quantity of goods production.
In large part, conflicts over technology leadership and national security have fueled the United States’ harder stance with China. The United States and China have ramped up barriers in a tit-for-tat fashion that raises the odds of partial decoupling of the technology sector. Even as both countries have legitimate national security concerns, it is difficult to imagine a full separation of the technology world into US and China spheres. Technology supply chains use specialized companies that cross multiple national borders. Further, China relies heavily on US manufacturers for certain core technology expertise, while US companies depend on the Chinese market for revenues. Despite dedicating resources to developing semiconductors since the 1950s, China is only about 15% self-sufficient today. As for the United States, large semiconductor companies generate as much as 40% to 60% of their revenues in China. A rapid transition to eliminate cross-border sales of technology components and expertise would strike to the core of both countries’ tech sectors.
Investors must recognize that in a bifurcated tech world, China’s tech products have more appeal to customers in faster growing emerging markets that more closely resemble China’s market a decade ago, while US tech products are more suited to developed markets. US efforts to clip Chinese tech companies’ wings could deliver a long-term advantage to China by improving their domestic technological capabilities and pushing them to focus on emerging markets with higher growth potential.
Tensions between the United States and China appear set to rotate from trade to investment. Thus far, despite rising tensions, China has further opened its domestic markets and worked to attract foreign investors. Indeed, China has every incentive to keep moving in this direction—the country requires foreign inflows, as its large current account surplus has shrunk. Additionally, China requires access to foreign capital to deal with its stressed banking sector. Expanded use of equity financing will facilitate corporate deleveraging, while expanding access to China’s government bonds will aid fiscal expansion. China is unlikely to close off its markets to outside investors unless aggression by Western governments forces its hand. The United States may be most vulnerable to financial decoupling since Chinese investors own massive amounts of US assets, particularly Treasuries, when the US dollar is expensive and foreign financing needs are growing.
The United States and China have reached a trade truce, but we expect some further decoupling. Trade and technology decoupling have potential to cause mutual economic pain, while the United States is particularly vulnerable should the trade war morph into a financial war. Geographic diversification is the first line of defense for investors under such conditions. We continue to recommend investments in public and private Chinese equities, while due diligence practices must incorporate an understanding of the changing investment landscape. We recommend overweighting Chinese public equities relative to global equities, as they better price in risks and may also benefit from strategic advantages over time in the event of continued tensions in the tech sector. Diligence in rebalancing positions in US assets and the US dollar back to neutral is a sensible defensive measure. As we go to press, we are watching the investment implications of the coronavirus. Readers would be wise to do so as well.*
* For more information on potential market implications of the coronavirus, please see our forthcoming piece.