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Does an Extended US-China Trade War Change the Strategic Investment Case for China?

Aaron Costello, CFA
Aaron Costello, Cambridge Associates

Aaron Costello

Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.

No. While we do not expect the trade war to end after President Trump and President Xi meet this week at the G20 in Japan, we have not changed our view that investors should consider dedicated allocations to China broadly and A-shares in particular.

Realistically, the best that investors could hope for from the June 28 meeting between Trump and Xi is another temporary truce, rather than a lasting end to hostilities. On both sides, the politics don’t support a compromise. For President Trump, the 2020 elections are more than a year away; striking a deal with China now could invite criticism from Democratic challengers, given anti-China sentiment on both sides of the political aisle. Furthermore, with US equities at all-time highs, there is less market pressure than last December when Trump and Xi met in Buenos Aires amid tumbling global markets.

For President Xi, China cannot be seen agreeing to terms that infringe on national sovereignty or caving into the demands of foreign powers, similar to the “unequal treaties” of the late 1800s. The breakdown in trade talks in May likely hinged on the United States demanding the right to automatically impose additional penalties on China for non-compliance without offering China any arbitration or redress. At the same time, the Chinese economy is on better footing given recent monetary and fiscal easing, and Chinese policy makers have a growing sense that the economy can withstand the hit from higher tariffs. Indeed, Xi Jinping has set the stage domestically for a period of hardship by declaring China is embarking on a “new Long March,” referencing the epic journey of the Red Army during the Chinese Civil War.

While economic incentives encourage Xi and Trump to avoid further escalation and reach a longer-term solution, the political incentives are not yet strong enough to force a breakthrough, and it is unlikely that the gap between the two sides has narrowed since May.

Thus, the most likely best-case outcome of the upcoming meeting is that both sides decide to resume negotiations, perhaps by delaying additional US tariffs on Chinese goods that are set to kick in after June. But expectations of any removal of tariffs or a long-lasting deal are misplaced.

Furthermore, it is clear that even if the trade war ends, the growing “tech war” with China will remain, given concerns over national security. This has the potential to split the technology world into a US sphere and Chinese sphere, which may have significant implications for the global economy.

Yet, this has not changed our view on investing in China. Equity valuations still favor China over the long term, even after the recent run-up. In addition, US and global equities are quite exposed to any worsening in the trade situation or fall in Chinese growth, however, investors seem quite complacent about these risks. At the same time, if markets fall in the short term, this would place more pressure on both sides to ultimately call a truce and for central banks to stay dovish. China may also have to increase fiscal stimulus further to offset the hit to growth, which may ultimately help boost Chinese assets if/when a truce is called.

In short, we are still comfortable with dedicated China allocations, because the market remains undervalued and the strategic case for China exposure (growing share of global benchmarks and ability for active managers to add value) remains in place. While some caution is warranted at the moment, the more Chinese assets weaken amid the trade war, the better the opportunity for investors to build allocations. This is especially the case if the world does ultimately split into two technology spheres, as investors will need exposure to both.

Aaron Costello, Managing Director on Cambridge Associates’ Global Investment Research Team