How worried should investors be as China and US relations continue to unravel?

Investors should accept that tensions between the world's two largest economies will remain on their risk radar for the foreseeable future. 

For the past few years, the US and China have been engaged in a trade war. Starting in 2018, the US began levying tariffs on Chinese imports to which China responded in kind. First concerns among investors were the impact this would have on global growth and the profitability of certain companies. For others, the trade war pointed to a deeper long-term risk, in turn raising the potential of the American and Chinese economies “decoupling”.

Either way, these geopolitical risks continually spooked markets in 2018 and 2019. Equity prices in European and Asian markets generally remained low as a result of both regions being heavily reliant on global trade. Meanwhile, during big flare-ups in relations, the US market saw sharp, albeit short, sell-offs.

So it was with great relief to investors that in January the US and China officially agreed to a truce in the trade war. The “Phase I” deal committed China to roughly doubling its imports from America as well as a commitment to clamp down on intellectual property theft. In return, the US agreed to suspend or reduce a series of tariffs on China.

The global outbreak of coronavirus, for the most part, put US and China relations out of the news. However, as geopolitical analyst Peter Zeihan notes: “Now, four months later, with the Americans emerging from their first coronavirus wave and edging back towards something that might at least rhyme with a shadow of normal, the bilateral relationship is coming back into focus.”

There are now several main points of tension. These include the extent that China is to blame for the Covid-19 outbreak, trade, telecoms giant Huawei, and the status of Hong Kong among other things.

First, notes Chetan Sehgal, manager of Templeton Emerging Markets Investment Trust (TEMIT), there has been concern that the fallout of the virus will result in the initial Phase 1 deal being reneged upon. He notes: “Concerns over the origin and spread of the virus have further sharpened the divisions between the two sides.”

On top of that he says there is concern that the “substantial change in the economic conditions as a result of the pandemic could also see both sides rethink the agreement.” Sehgal, however, is not too concerned, noting: “We still expect that the parties will still try to meet the obligations.”

Analysts at Goldman Sachs are also relatively confident that the US will not back out of the deal. “This seems unlikely to be the primary US response to the deterioration in US-China relations in our view. A tariff increase would increase costs to consumers and businesses while their income has been reduced by the economic fallout from the coronavirus crisis.”

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The latest point of tension, however, has come as a result of Chinese authorities recently passing a resolution paving the way for the creation of a national security law for Hong Kong. This law, it is argued, would effectively result in Hong Kong being ruled directly from Beijing, ending the city-state’s autonomy.

This could have major ramifications for how the island is treated by the US. The island is currently viewed as autonomous by the US and therefore exempt from American rules relating to China (such as tariffs). However, with the US now labelling Hong Kong no longer autonomous due to the national security law, that separate treatment has been thrown into doubt.

Sehgal, however, is broadly unconcerned for now. He notes: “Losing Hong Kong’s favoured status could have repercussions for the city but less so for China itself and we believe that if the geographical tensions do not escalate beyond Hong Kong, the situation should stabilise.”

The view of Goldman Sachs is that while the US may say it no longer designates Hong Kong as autonomous, this will not necessarily result in huge changes. Analysts note: “We view targeted policy changes or sanctions as much more likely than a wholesale shift of US policy to treat HK the same way as the mainland.”

Another, less noted risk has been the US forcing its main federal government pension fund from investing in China. The US Federal Pension fund was due to invest roughly $40 billion in the MSCI All Country World ex-US Investable Market index to gain non-US exposure. Approximately 11% of that index is Chinese companies. According to president Donald Trump and others, having American money invested in some of these companies would be against American national interests.

As a result, these plans have been dropped for now. Sehgal says that he does think this in itself is much of a concern, noting that the anticipated investment of about $4 billion is tiny compared to the overall size of the Chinese market, which currently stands at $12 trillion.

But, Sehgal warns that while this was more symbolic, “if many more funds are forced to exclude China, there could be serious ramifications.” He continues: “We view the probability of such an event as less likely, given that capital market restrictions have generally not been effective in ensuring change. However, the prospects of limited sanctions on entities could still be enacted.”

The Chinese response

As tensions increase, eyes will be focused on how China will decide to respond. For the past two years China’s response to the trade war has broadly been reactive and proportional; sanctions from the US have been met with similar sanctions from China.

According to Goldman Sachs, this is not likely to change this time around. They note: “We think the 2018-19 playbook of imposing retaliation only after the US has actually changed policy, and even then responding proportionately or slightly less than proportionately, will likely remain in force.”

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However, should China choose to escalate, there are several options on the table. First, China could attempt to further weaken its currency compared to the dollar. This boosts Chinese exporters’ margins while harming US exporters. Analysts at Goldman Sachs, however, expect this to be unlikely. They note: “We think the chance of an engineered depreciation is very small, though policymakers would likely accept some modest depreciation if tensions continue to intensify, especially if there were a breakdown in the trade deal or a major increase in capital outflow pressures.”

Another option would be to target US companies, restricting their ability to operate on Chinese territory in much the same way the US has targeted firms such as Huawei. Many investor favourites such as Apple and Tesla have a strong presence in China.

This, however, appears unlikely, according to Goldman Sachs analysts. They point out that China has expended a lot of effort presenting itself as an attractive investment destination. Targeting US companies would quickly undermine this.

For investors, the scariest response would be a sell-off of US treasuries. In recent years the Chinese government has been building up a large portfolio of US bonds. In theory, they could sell these holdings, causing downward pressure on US bonds and spiking US borrowing costs. This would have a ripple effect, raising interest rates across the US economy. This would be seriously damaging to economic growth, sending the US back into recession (assuming the coronavirus recession is over).

Thankfully that option is highly unlikely. Such policy would likely harm China almost as much as the US. As Goldman Sachs notes: “We view disruptive actions by either the US or China in this area as unlikely. Abrupt large sales of Treasury securities or other US assets could tighten financial conditions well beyond the United States, so would appear an unattractive approach for Chinese policymakers for both political and economic reasons.”

No end in sight

With Trump officially starting the trade war in 2018, some investors could conclude that if he loses the election later in the year, tension will begin to ease.

Sebastien Galy, senior macro strategist at Nordea Asset Management says that if Donald Trump is re-elected as president, tensions will likely increase further. He notes: “We should expect a rapid ramping up of such measures, as China is very unlikely to fulfil its requirements under the phase one trade deal agreement. The agreement is egregiously one sided.”

However, that is not to say Trump losing will result in a return to anything approaching friendly relations between the two powers. Galy continues: “The confrontation between China and the United States will go beyond the current US administration. The trade war may ebb under the Democrats, but it will not go away, as too few countries are competing for too little growth.”

Chinese and US relations have now fundamentally changed and both states now view themselves as locked in a competition for power with one another. While the fallout of this new cold war should not be too damaging for investors and markets for now, or at least in the short term, investors should accept that this conflict will remain on their risk radar for the foreseeable future.