As the one of the first countries to recover from the social and economic effects of coronavirus (and assuming that there is no second wave), China’s determined by two drivers: Chinese economic policy while the rest of the world struggles and American policy towards China.
With regard to domestic economic policy, we have long highlighted that, as a country with capital controls and a financial system funded in its own currency, China enjoys a very powerful set of tools with which to manage its economy. These come, of course, with various institutional constraints, including a hawkish central bank with a great sensitivity to consumer price inflation, and also the sensitivity to currency volatility of both domestic savers and also key trading partners (more on this later).
This is a time for countries with inherent strengths in state capacity to use them to limit the damage that the coronavirus response has wreaked on economies and societies, and the Chinese government has been moving to provide the fiscal and monetary support that is needed.
The other big determinant for China will be its relationship with the US, or, to say it like it is, the great power struggle between the existing hegemon and its challenger.
Great powers in the modern era compete in a variety of arenas and with a variety of methods. Whilst much is made of the parallels with the Cold War, and we do note these, there are many ways in which the US-China struggle resembles more the rise of a unified Germany in the early twentieth century, and its competition with Great Britain, the incumbent hegemon. In this note we seek to explore some of the dimensions of the current tension and what it might mean for markets.
The final argument of kings
Direct military competition is the most basic form of geopolitical rivalry (cannons were, in Louis XIV’s view, ‘the final argument of kings’). US-Chinese military competition has been building for the last 20 years, accentuated by the cross-currents of China’s territorial disputes with its neighbours. Beijing had previously been cautious in these matters, but as its military strength has hugely overtaken its neighbours’, China has deployed hard power in the region. Naval and other manoeuvres designed to intimidate US allies Japan and Taiwan, as well as ongoing border clashes with India and developing claims on the South China Sea are all a challenge to the willingness and ability of the US to protect its position in the region.
The American response to this challenge has been mixed. An administration elected with a mandate to reduce US involvement overseas is in disagreement with a security establishment convinced of the need to assertively strengthen American military capability and reassure concerned allies.
These kind of minor conflicts were seen in both the German-British tension and during the Cold War, although in the latter through allies and proxies than directly between US and Soviet forces. The market impact of military competition is hard to analyse. It is essentially binary, with tensions having a very limited effect on markets, and superpower military conflict being unpriceable.
An end to ‘death by China’
A second area of competition is supply chains. A key plank of the Trump administration’s economic policy, substantially driven by the president’s economic adviser Peter Navarro (the author of ‘Death By China’), has been the view that the two economies have become too interconnected, at the cost of supply chain risk, loss of American jobs, and weaker national security. China’s heavily state-driven economy and its aggressive acquisition of research and technology has amplified these concerns. Also exacerbating this has been the coronavirus pandemic and shortages of critical medical equipment and supplies outside China. The US is now directly planning to promote domestic production of products such as pharmaceuticals and semiconductors and wider national industrial planning is being considered.
This tension between the economic gains from specialisation and trade versus the security of domestic supply is far more than what was seen in the British-German competition than in the Cold War. German Chancellor Otto von Bismarck was critical of Great Britain’s free-market system and promoted protectionism, managed economic development and the creation of domestic cartels tasked with serving the national economy. German banks (as Chinese ones today) were tasked with organising and financing these cartels, as well as financing strategic infrastructure. As in the Chinese-US relationship, Germany’s coordinated and protected economy allowed the country to become highly competitive, even in British markets. Similarly, restrictions and tariffs were seen in the UK as they are now appearing in the US.
The severing of trade links will be an economic negative for all countries where it happens. The great thrust of global growth in the emerging world and low inflation in the developed world has been off the back of globalisation, and de-globalisation could put this all into reverse. Possibly accentuating this is the spread of this wider than just between the US and China, with American unhappiness at other trade partners such as the EU, Japan and South Korea, while other manifestations such as Brexit are also appearing.
De-globalisation and the consequences
This seems to offer a negative outlook for emerging markets, including the three largest markets of China, South Korea and Taiwan. However, there will be three substantial constraints on the unwind. Firstly, the economic logic will not go away while labour costs remain so different between rich and poor countries. Secondly, in areas with highly specialised products and strong network effects, it will be very difficult to replace existing production (this is particularly true of electronics – consider the underwhelming result of Hon Hai’s plans to relocate some production to the US). Thirdly, trade between developing countries continues to grow rapidly and can to some degree offset declining exports to the US.
Technological double standards
A third area of competition is access to technology. This has particularly been happening in new information and communication technology areas, such as semiconductors, artificial intelligence and 5G wireless technology. Scale and government support and subsidies have allowed Chinese companies, particularly the equipment supplier Huawei, to supply digital infrastructure quicker and cheaper than American or European competitors. Security concerns, and probably fears about competitive positions, have meant that the US has pushed back hard, restricting the supply of components to Huawei and compromising its ability to sell equipment in the US and allied countries.
This is likely to lead to the development of a two-world environment in communications equipment, in which some countries adopt Chinese standards and equipment and others US standards and American and European equipment. To see how this would work, consider the online world, in which Western apps and services are mostly useless within China, while Chinese apps and services are mostly irrelevant outside China.
Again, this pattern is very much seen in the German-British competition, with the parallels in the radio transmission industry very clear. Britain sought to constrain domestic and allied users to the British-backed Marconi standard, while the German government sought to create a rival, forcibly merging German firms into a state champion, Telefunken, which the government then sought to promote internationally.
The success of both US and Chinese online companies suggests that a two-world outcome is not a barrier to spectacular stock performance in both halves. However, hardware is a far more competitive and mature industry, and the loss of large potentially accessible markets must be negative, although this is likely to play out at the firm- and industry-level rather than at the national economy level.
Different future outcomes mean need for country-led analysis
The China-US competition has a long way to go. Competition for military edge, trade and supply chain networks, technological access and for financial, institutional and cultural supremacy will be part of Asian and global geopolitics for years to come. Given that the competition between the United States and China will endure, both companies and investors will need to find ways to navigate this reality. The fact that the German-British struggle ended in combat and the Cold War did not means that a wide range of outcomes are possible, but we feel that monitoring this from a top-down, country-level perspective can provide clues to the twists and turns as they emerge.
Author: James Syme, Senior fund manager for the Global Emerging Markets Opportunities Fund, J O Hambro Capital Management. Contact your financial adviser to find out more.
Past performance is no guarantee of future performance.
Source: JOHCM/MSCI Barra/Bloomberg, NAV of Share Class A in USD, net income reinvested, net of fees as at 31 May 2020. The A USD Class was launched on 30 June 2011. Benchmark: MSCI Emerging Markets NR (12pm adjusted). Performance of other share classes may vary and is available on request.
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