MARKET COMMENTARY

Thoughts on US-China Trade Issues

07.01.2020 - Joseph Portillo, Senior Portfolio Manager

Key Takeaways
  • The risks of a trade war are large for both the US and China, but China risks falling behind the technological curve and rising domestic unrest.
  • Many multi-national companies are considering moving their manufacturing facilities out of China.
  • We are investing in companies which have the scale and flexibility to manage potential supply chain disruptions.
China was the first country to experience the COVID-19 outbreak, before it became a global health crisis. Because China had to shut down much of its economy to contain the outbreak, many important global supply chains were disrupted. This initially caused a supply shock and, as the disease spread across the globe, it also caused a demand shock due to lockdowns in many countries.

US-China Trade: Tough Talk Continues
Prior to the COVID-19 outbreak, the US government was engaged in heated trade rhetoric with China that increasingly pointed to a trade war, and the tough talk has continued. The US position has been that China needed to play on a level playing field and, crucially, respect intellectual property rights.

The two countries began levying tariffs on each other, but eventually this tit-for-tat exchange led to a “Phase I” trade deal and the reduction or suspension of some tariffs.

China is Falling Short of Agreed-Upon Import Targets
The Trump administration has been walking a fine line between blaming China for the outbreak while simultaneously talking up the Phase I trade deal as “the greatest ever.”

COVID-19 has made it difficult to determine if China is meeting its targets. China’s economy is in recovery mode but appears relatively weak compared to historical norms. Recent statistics suggest that China is making some efforts to meet import targets. However, the country’s imports will need to ratchet up significantly in the final months of the year to meet the negotiated targets.

Pressure is Likely to Remain on China
The Trump administration will likely continue to put pressure on China but will most likely avoid further severe tariffs as these will not be popular with corporations during a recession, could depress consumption and could negatively factor into broader reelection prospects. The Trump administration will likely use rhetoric suggesting that China is “making progress” as opposed to asserting non-compliance. The deal should remain mostly intact and will either be pursued, renegotiated or junked depending on the results of the election.

A new wrinkle that neither US political party will likely condone is Beijing’s recent decision to press ahead with a new unilaterally approved Hong Kong security law aimed at suppressing dissidents. At this time, it is difficult to assess how the US might react until more details are available. In any case, pressure will remain on China for the foreseeable future regardless of which party comes out ahead in the November election. The COVID-19 crisis has hammered home how overly dependent some global supply chains (e.g., pharmaceuticals and technology) have become on China, and both US political parties understand that intellectual property misappropriation is a major issue.

Intellectual Property Issues Loom Large
The US has stringent new rules on the transfer of intellectual property into China. Recent regulatory changes limit the sale of leading-edge semiconductor production equipment to China or Chinese-affiliated companies without specific export licenses. This is a change from earlier actions that targeted sales of certain equipment to specific companies thought to have Chinese military ties.

The power of these changes cannot be dismissed. For example, a Chinese company with a leading position in semiconductors and other components that are needed to power the next generation of 5G wireless networks (along with many patents in this area) may not have the advanced production knowhow to produce the semiconductors that they designed and patented. Essentially, the firm needs access to US technology.

Under the new regulations, for example, companies that have the technology might not be able to produce certain chips for Chinese firms because their production equipment uses critical US patents. If the US doesn’t issue an export license to such a foreign firm, then Chinese companies won’t be able to obtain semiconductors to power their products. As another example, a Dutch company that makes scanners may face a similar outcome. Critical components used in its machinery are sourced from companies holding US patents. So even this Dutch company would need a US license to sell equipment in China or to companies exporting to China.

Semiconductors Versus Soybeans
It’s estimated that if China tried to go it alone and cultivate its own domestic semiconductor industry purely with homegrown technology, it would take them five to 10 years to catch up to most advanced global companies. One leading Chinese firm appears to have a chip inventory stockpile that will only meet its needs for 12 to 18 months. If a deal is not cut, the company will not be able to capitalize on its advanced chip designs.

The Chinese government responded by imposing new tariffs on US soybeans. This was an asymmetrically weak response to the issue, likely put into effect by China to try and save face by taking some kind of trade-related action. The US seems to be holding the stronger hand regarding technology transfers.

Manufacturing Returning Home
Overreliance on China in key areas has the US and other industrialized companies rethinking their supply chain strategies.

Chinese production costs have been rising as the nation has industrialized. The cost advantages are not as substantial as they had been in the past and this, as well as the potential for supply chain blockages, means that countries such as the US may look to bring some production back home or to other offshore production bases with friendlier regimes. We do not think that globalization is completely dead. However, supply chains could increasingly be redistributed outside of China.

“Reshoring” some parts of the supply chain will take time and may have some inflationary consequences due to higher production costs in the US. It is unclear how this might play out since there is a tradeoff over securing supply chains at higher costs versus facing possible future supply disruptions. These effects will depend on the nature of the supply chains that relocate to the US.

This may allow the US to attract investment into the country. In fact, we may be in the early stages of this. For example, an Asian semiconductor firm recently announced that it will build a new production facility in a western state. The US may risk losing access to some Chinese markets over time, but as the Chinese economy has continued to industrialize, China itself has chosen to prefer locally produced goods in many mass consumer categories (e.g., automobiles).

As for China, the risk of falling behind the technological curve and being unable to bring its advanced technological products to market are huge issues. Aside from losing access to critical technologies, China also must worry about domestic unrest. If supply chains start to relocate, this could mean job losses in key Chinese cities and, in the worst case, could stir up civil unrest. China will undoubtedly want to avoid this outcome.

There Are Risks for Both Countries, but China May Face a Steeper Downside
China and the US each have quite a bit to lose if they cannot come to a more lasting understanding on trade as well as on intellectual property transfers. However, the greater level of risk seems to be skewing toward China. We expect rhetoric to remain heated on both sides but think that actions will be more muted, especially ahead of the US election. If the US does impose more restrictions on China, the response from China will likely be measured and proportionate in order to try and contain further escalation and to save face.

In the end, it would be better for both sides to strike a deal and negotiate with each other in good faith and come up with a framework in which compliance can be verified. We assume that this will be a long process due to the complexities of the issues involved. While it is still a bit early to pick long-term winners and losers, the possible effects of US-China trade relations factor into our thinking as we look for industries, sectors and companies that can benefit from trends such as reshoring and supply chain relocation.



The information provided is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy, or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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