In the latest instalment of our editorial series, Link, Aviva Investors experts discuss the prospects for financial markets and the world economy in the face of escalating hostilities between the US and China.
US-China relations have been fraught since 2017
US-China relations have been fraught since 2017, when the incoming Trump administration started placing tariffs on Chinese imports, ostensibly in retaliation for a bilateral trade imbalance and alleged theft of American technology.
After months of negotiations, a phase-one trade deal was finally agreed in December 2019. China agreed to address some of Trump’s concerns, pledging to buy more US goods and to protect the intellectual property of American businesses operating within its borders.1
But the US-China relationship has deteriorated further since the onset of the coronavirus pandemic. The crisis has precipitated a war of words: Trump has blamed Beijing for the spread of what he calls “the China virus”; China has responded by suggesting COVID-19 originated as an American plot.2
Meanwhile, the US has expressed support for protestors in Hong Kong and threatened to revoke the territory’s autonomous status in response to Beijing’s new security law. Trump has also imposed stricter controls on exports to China’s national tech champion, Huawei.3
With anti-China sentiment on the rise across the US, the situation could worsen before it improves
With a presidential election on the horizon, and anti-China sentiment on the rise across the US,4 the situation could worsen before it improves. So what are the implications of the US-China spat for the global economy and markets? The AIQ editorial team brought together Harriet Ballard (HB), senior multi-asset strategist, and Alistair Way (AW), head of emerging market equities, to discuss the key risks.
AIQ: Are we seeing a fundamental change in the US-China relationship, or is this just a case of heated rhetoric?
HB: If you look at the US-China dispute before the coronavirus, compared with now, the biggest difference is that you can’t call it a trade war anymore. It is much broader than that.
There are various areas of tension. Trump has fallen in the polls; the economy has been hit; and being tough on China is a vote winner in the US. That’s a large part of why this has come to the foreground. Trump is trying to blame China for the virus and wants to have an international investigation into it – that is very contentious.
Then you have China’s relationship with Taiwan. The US supports the Taiwanese government and that is causing tensions. The Hong Kong situation is another axis. There is bipartisan support in Congress for the protestors. Republicans and Democrats are also united in condemnation of China’s violations of human rights, including the mistreatment of the Muslim communities within its borders.
The response to coronavirus has been marked by mistrust and blame
AW: It feels to me like the relationship between the US and China has fundamentally changed. There is far more to it than Trump himself. When the coronavirus hit, you would have hoped the two countries could have done a much better job of working together given this is a global economic and healthcare crisis. But from the start, it has been marked by mistrust and blame.
The channels of diplomacy between the two countries are worse than they have ever been, which makes things harder. If you have experts on the ground who are aligned with each other it creates a natural buffer, even if the leaders are at odds. But that doesn’t seem to be the case now.
There is a particular risk that kneejerk decisions will be made in an election year. There’s bipartisan political approval for getting tough on China and the majority of US voters are anti-China, according to recent opinion polls. It does feel like we are moving into a trickier situation.
AIQ: Could these tensions threaten the phase-one trade deal agreed in January?
HB: Our base case is that the phase-one deal remains in place, but the risk that it collapses has definitely increased because China is not on track to meet the obligations stipulated in that deal, such as buying more agricultural produce from the US.5 The US is showing no leniency, despite the coronavirus crisis. There is a semi-annual review of the phase-one deal in August. If China continues to undershoot its targets, the agreement could come under scrutiny.
AIQ: What are the key investment risks?
AW: There are a lot of moving parts. From a bottom-up equity investment perspective, we’re focusing on the implications of new US restrictions on exports to Huawei;6 threatened controls on US institutions investing directly into Chinese equities;7 and the increased auditing demands on US-listed Chinese companies such as JD.com, Alibaba and Baidu.8 The markets have had a chance to discount these hazards, but if things get worse, with a fracturing of the trade deal and tariff escalation across sectors, there is still a lot of downside risk, especially in the equity market.
It’s impossible for the Trump administration to be too “anti-China” without damaging his own country’s interests
An escalation in the trade war is not our base case, because that would inflict further pain on US companies and consumers; a key trade-off that even Trump would have to recognise in an election year. It’s simply impossible for the Trump administration to be too “anti-China” without damaging his own country’s interests, so there is a measure of economic protection against anything too bad happening this year. But there’s still a lot to be concerned about.
Take the Chinese response to the Huawei situation, which is quite different from 2018. There has been less economic retaliation – although some further restrictions on companies such as Apple have been mooted.9 The response has been more about sabre-rattling regarding Hong Kong and Taiwan. This is not just a repeat of 2018: there is a whole different set of variables and a much broader global response to what China is doing, rather than a simple economic war in which investors try to work out the winners and losers.
AIQ: Is there a risk the confrontation might escalate on the economic front? Could the US cancel the $1.1 trillion in debt it owes China, for instance? Could China simply dump its holdings of Treasury bonds?
HB: It is highly unlikely either side would go down this route, even though Trump has occasionally threatened to default on the debt. Cancelling China’s holdings of Treasuries would be a colossal economic shock that would have a huge impact on the US Treasury market and global financial system. That would be hugely counterproductive.
AIQ: Are other countries also changing their stance towards China?
HB: In the last phase of the trade war, other developed markets tried to separate themselves from US-China tensions, condemning counterproductive tariff measures. More recently, however, especially when it comes to the situation in Hong Kong, you are seeing a much bigger international response and support for the tough US stance.
In late May, the US, UK, Canada and Australia issued a joint statement condemning the decision to impose a new national security law, as it was in direct conflict with the UN-registered Sino-British declaration that handed the territory back to China. That kind of joined-up international response was something we didn’t see as part of the previous trade war rhetoric. It could potentially embolden Trump.
AIQ: How could the outcome of the US election change the picture?
HB: If Biden wins, the Democrats would likely go further down the path of multilateral action, seeking international support in the interests of collective leverage. In the long run, that could be economically far more meaningful for China than the bipartisan tariffs that have been imposed so far.
AIQ: How about smaller emerging economies – will they be forced to take sides?
AW: Most countries will be keen not to take sides, given the downside of a bad relationship is always going to outweigh the benefits of stronger allegiances. A country like Taiwan is being forced into a difficult position given the way its companies are integrated into both Chinese and US technology supply chains. Taiwanese chipmaker and Huawei supplier TSMC recently announced a huge investment in the US, perhaps as a way of avoiding sanctions.10
The benefits of being compliant with the US and alienating China are not clear to me
In the shorter term, it is probably easier to go along with the US rhetoric given the unpredictable nature of Trump. But over the longer term, countries and companies need to set that against the huge economic importance of China. Does it make long-term sense to pick sides with the US? For the bulk of the world, the benefits of being compliant with the US and alienating China are not clear to me.
Take Huawei. It has been reported UK Prime Minister Boris Johnson is now rethinking the use of Huawei in the country’s 5G telecommunications infrastructure, despite the fact the UK has long been aware of potential security risks and had already decided to go ahead with Huawei in the face of US criticism.11 Huawei has far better – and far cheaper – equipment than Nokia, Ericsson and Samsung. It would be difficult to cut China out without significant supply chain and pricing pain.
AIQ: How could the situation in Hong Kong play out? Could foreign investors’ access to mainland markets come under threat if the territory’s autonomous status is revoked?
HB: The US said it no longer sees Hong Kong as an autonomous territory. However, the policy consequences of that declaration are very much in the hands of the president. The historical benefits of being an autonomous territory are not automatically removed. Targeted sanctions against people and entities are the most likely outcome, particularly against companies involved in law enforcement and surveillance within Hong Kong.
If the US completely removed the treaty and provisions Hong Kong gets as an autonomous region, it would be subject to the same tariff rules as China. From an economic point of view, the impact of that is not hugely significant, as there is not much manufacturing in Hong Kong itself. Such a move would be a political signal to China rather than an economic hit to Hong Kong. Trump’s statement is unlikely to bring about any substantive change in the territory’s position as an export hub or, in the near term, a financial access point to mainland markets. That said, over a longer horizon, China’s increased influence in Hong Kong may weaken its attractiveness as a business centre.
AW: Hong Kong has such a special place in terms of access to China. There are a lot of US businesses based in Hong Kong and it would be quite hard to change the status without significantly harming them.
Hong Kong may benefit economically over the longer term from the tensions between the US and China
In fact, the territory may benefit economically over the longer term from the tensions between the US and China if mainland companies are forced to delist from US exchanges and move their primary listing to Hong Kong. A forced delisting of a large swathe of the Chinese equity market away from Nasdaq to Hong Kong would be massively beneficial for trading volumes on the Hong Kong Exchange. It would shift the centre of gravity of emerging market investing much more locally. But given the precarious nature of Hong Kong in the current environment, the picture could quickly change.
AIQ: How can investors ensure their portfolios stay resilient in this uncertain environment?
AW: We are focusing on how to protect clients’ assets given the changing news flow and the focus on technology supply chains. It is a difficult environment, and investors will seek exposure to companies that would be expected to perform well in an environment of deteriorating trade relationships.
Investors also need to monitor the Huawei situation. The targeted sanctions against the company are probably not bad enough to be negative for global markets in aggregate, particularly given Huawei is not a listed company, and the impact is insignificant compared with the wider demand destruction caused by the pandemic. But this feels like the latest development in a constant ratcheting-up of tensions. I am not sure the risks on how this plays out are currently priced into markets.