Market risks are rising as US, China tensions escalate toward new cold war
- Tensions between the U.S. and China escalated sharply after two U.S. moves this week.
- The U.S. indicted two Chinese hackers for allegedly targeting American companies involved in virus research, and then ordered the shutdown of China's Houston consulate.
- Wall Street firms have been examining the potential consequences of the fraying relationship and expect there will be an increasingly polarized global economy.
- The barbs between the U.S. and China are expected to worsen as the presidential election gets closer, and they should continue to ramp up regardless of the outcome.
The growing divide between China and the U.S. is expected to accelerate, disrupting long-running economic ties and forcing investors to reassess their view of global markets.
Tensions escalated this week after the U.S. claimed two Chinese hackers were targeting American companies working on virus research and were stealing information from companies around the world, both for profit and on behalf of the Chinese government. Then, the U.S. ordered the shutdown of China's Houston consulate, claiming it was a necessary step to protect intellectual property and the data of private citizens.
Wall Street firms have been examining the implications of the reversal of a decades-long effort to form a more symbiotic relationship between the world's two largest economies. One consistent view is the world will be far more polarized, with economies and companies gravitating toward either a Chinese or an American orbit.
But the realignment could be even more complicated.
"Given, the Covid-19 crisis, how China handled the early stages of it and now the imposition of the national security law on Hong Kong, it's really difficult to see how the U.S. and the West and China can get back to normal," said Jimmy Chang, chief investment strategist at Rockefeller Asset Management. "The decoupling will only gain momentum in the coming year, unless there are major policy shifts within China. At this point, it doesn't look likely."
The latest friction nevertheless had little market impact as major averages opened slightly higher Wednesday. Beijing vowed to retaliate unless the U.S. rescinded the order to close the consulate.
Chang argues that investors should be paying even more attention to the unraveling relationship between Washington and Beijing. He said they instead are focusing on how world markets are benefiting from massive fiscal and monetary stimulus. The resulting relocation of supply chains and shifting trade patterns could have significant impact on some companies and economies.
Longtime market bull Ed Yardeni warns that in addition to the coronavirus, the deteriorating relationship is one reason why he sees the potential for a market pullback of more than 20%.
Wall Street assessing decoupling
In its second-half outlook, BlackRock said the pandemic is fueling dynamics between the U.S. and China that were already underway.
The "rivalry looks set to affect nearly every dimension of the U.S.-China relationship — regardless of the U.S. election outcome," the firm said. "Other countries will increasingly be pushed to choose sides. Decoupling is focused on — but not limited to — the technology sector. This means investors need exposure to both markets, especially as the center of gravity of global growth is moving to Asia."
The markets for the most part have looked past the tension, but there could be periods of unease that could create headwinds.
"I think you only need to roll back the clock 12 months to a moment when these kinds of pronounced frictions between the U.S. and China, particularly around escalating trade disputes, had a real impact on risk-on risk-off sentiment," said Mike Pyle, BlackRock's global chief investment strategist.
Pyle said there were recent signs of that when Secretary of State Mike Pompeo took action to decertify Hong Kong's status as separate from China and deny visas to some Chinese nationals. Asian equities responded to that as well as to the U.K.'s recent announcement that it would ban Huawei from its 5G network. The U.K. followed the lead of the U.S., which has cracked down on the Chinese telecom giant and restricted access to U.S. suppliers because of allegations of cyber espionage.
For investors, the implications are significant and should be considered when structuring portfolios.
"I think there are any number of trades to be thinking about. One of the important themes is building a more balanced set of exposures to the two big engines of global growth," Pyle said. "The U.S. and North America more broadly, and East Asia, rooted in China. … It would be exposure into China assets themselves or indirectly through Taiwan, through Korea, through Australia, through Japan."
Pyle said that previously, investments had been designed to benefit from globalization, but that trade is now splintering.
"The economies are going to be less correlated and financial markets are going to be less correlated," he said. He pointed, for instance, to the higher yields on Chinese sovereign debt, which were rising, as U.S. rates moved lower in recent weeks.
Politics could raise tensions
Analysts expect to hear more anti-China rhetoric as the November presidential election gets closer. The Trump administration's actions against China are also likely to mount.
"On one hand, they want China to buy agricultural goods, but on the other hand, it's very effective making China the target," Chang said. "You will see both parties coming up with anti-China positions as a way to win votes. I do think there's a bipartisan consensus to get tougher on China. I do anticipate after the election things will move at a faster pace."
Chang said that from the Chinese perspective, being tough on the West could play well at home. Neither side is likely to reverse course. At a symposium Tuesday, China President Xi Jinping vowed to continue strengthening China's domestic market while further opening to foreign investors. Xi was quoted as saying China was "on the right side of history" in its continued commitment to globalization, and he encouraged Chinese companies to expand operations overseas.
"The mutual trust has been lost. For decades, the West kept saying if you do more trade with China, you have openings with them and they become more like us, but the opposite has happened in the last few years," Chang said.
There could ultimately be fallout for U.S. companies, but Chang notes for now they have not been targeted by China. Analysts say Apple could be vulnerable, both because of its China revenues and supply chain exposure.
"So far, China has been playing nice with American companies because the Chinese government tends to look at American businesses as their lobbyists in Washington," said Chang, noting Beijing is using its Belt and Road infrastructure development strategy to gain influence with other countries.
U.S. Attorney General William Barr last week slammed U.S. technology companies for being "pawns of Chinese influence." He said tech companies and Hollywood were "all too willing to collaborate with the Chinese Communist Party." Both Apple and Cisco denied specific claims made by Barr.
This week, the U.S. barred 11 more Chinese companies from buying American technology and other products without a special license. The U.S. said the sanctioned companies were involved in human rights violations related to China's targeting of Muslim Uighurs in Xinjiang.
The 11 companies are current or former suppliers to major international brands, including Apple, Alphabet, HP, Hugo Boss and Ralph Lauren, according to a New York Times report.
The fraying of the U.S.-Chinese relationship also intensifies the divide on national security issues The U.S. objects to China's claim of dominance in the South China Sea, and Asian countries who benefit from trade with China also look to the U.S. as a counterbalancing force.
"We really are at the beginning of this stage, and it has deep implications," Chang said. "The rise in global trade and China becoming the world's factory is a multidecade trend. You're talking about almost a 20-year trend going into reversal. What it means to supply chains, pricing and inflation down the road is also a very gradual transition. Moving away from China in the supply chain will take years to realize."
Pyle said multinationals are already working to redirect their supply chains from China and that should increase.
"This results in higher costs of goods sold. The question is does it manifest itself in compressed profit margins or higher end prices, i.e. greater inflation risk," he said. "The variable that will distinguish is what firms will have super-star status," meaning they have the ability to pass price increases to customers.
"When the two biggest economies start to decouple, there's going to be some impact. So many multinationals benefited for so many years from shifting manufacturing to China, lowering their costs, enhancing their margins," Chang said. "When you reverse that process, how much damage will be incurred?"
For U.S. companies selling goods in China, he said the government could make it more difficult in terms of tariffs or by creating a backlash against foreign products to favor domestic companies. A transition phase as companies shift their production is likely to have a mixed impact on companies.
Energy expert Daniel Yergin, vice chairman of IHS Markit, said the realignment will also have a mixed impact on countries that may find themselves caught in the middle. He has spent a lot of time examining what he calls the move toward a new cold war. He and others say there could be a multipolarizing of interests as Europe pursues its own trade strategies.
"A lot has to do with how important China is to your country. Germany is going to look at it differently than England," he said. "China is very important to its economy. This is going to be complex, and we're going to discover the world is a lot more interconnected than people realize."
Investing for the new world order
Morgan Stanley, in a recent note, studied the potential impact on 35 industry sectors of the decoupling of the two economies.
Eleven sectors will most feel the brunt of increased costs and other challenges to business operations. They include global auto and component makers; global transportation and aerospace; global capital goods, U.S. IT hardware and internet, and U.S. and Asian semiconductors.
Thirteen sectors should benefit from continued globalization, including global chemicals, beverages and luxury goods. Global pharmaceuticals, biotechnology and medical technology also benefit. U.S. banks and insurance companies were on that list.
"That is, the benefits from continued globalization — new markets and more diverse supply chains — outweigh the challenges," the Morgan Stanley analysts said.
As for American capital markets, the U.S. wants to crack down on Chinese companies' listings. Companies would be required to show they had no foreign government ownership and submit to audits.
At the same time, one of the year's biggest IPOs, fintech firm Ant Group, an affiliate of Chinese e-commerce giant Alibaba, has planned its dual listing completely in China, on Shanghai and Hong Kong exchanges.
The Peterson Institute for International Economics recently published a paper that argued it would be pointless to delist Chinese companies. It noted that the integration in the financial sector looks likely to increase despite President Donald Trump's warning that "a complete decoupling from China" remained a policy option.
U.S. financial institutions are increasing their presence in China, where authorities have been loosening rules on foreign ownership. The Peterson Institute listed examples of American companies expanding their role, including Goldman Sachs which was approved in March to raise its stake in joint venture Goldman Sachs Gao Hua Securities to 51%. Morgan Stanley was also given approval to raise its stake in its joint venture securities firm, Morgan Stanley Huaxin Securities, from 49% to 51%.
In their report on decoupling, the Morgan Stanley analysts said there should also be some regional winners, which would include Asian internet and European enterprise software, which benefits from regulatory protection in a "multipolar world." There are also sectors that will not be much impacted at all, such as global energy and global metals and mining.
"From the standpoint of global trade, I think global trade will be negatively impacted. In terms of weaker or stronger, you can argue there's always that transition that will hurt some companies but help others," Chang said. The same could be true of countries "Could India become a beneficiary as many Western companies move their supply chains? Or Indonesia?"