Trade War latest – the result Trump didn’t want

Fri 24 May 2019

By Brian Dennehy

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The technology cold war between the US and China has continued apace in recent weeks, in particular since our blog on Huawei. But as sanctions on Huawei have sharply increased, counter-intuitively the long-term attractions of China have increased – not what President Trump intended.

The technology cold war between the US and China has continued apace in recent weeks, in particular since our blog on Huawei. But as sanctions on Huawei have sharply increased, counter-intuitively the long-term attractions of China have increased – not what President Trump intended.
In this blog I want to consider what has held back Chinese equities versus the US, the opportunities being overlooked, and the extent to which those opportunities are being enhanced by Trump’s trade war.
Shock – greedy directors
I’ve talked a lot about the extent to which the US stock market has been driven higher, much higher than its peers, due to share buybacks financed by companies issuing bonds - which in turn has been made much much easier by the actions of the Federal Reserve. (See here for more on this and the executives lining their pockets financial engineering). Surprisingly this was only picked up by the Wall Street journal in an article in recent weeks under the headline “A surprising connection between the bull market and stock buybacks”.
The article noted that over the last 10 years China’s economic growth after inflation was 8% annualised, compared to 2.1% annualised for the United States. Yet US equities over the same period returned more than double that of China’s. We know that over very long periods a country’s economic growth will be largely reflected in stock market growth. But this is a great example of how over shorter periods, in this case 10 years, markets can also be driven by financial engineering (let alone by basic issues such as extremes in confidence).
The article goes on to highlight that the research, from the Abu Dhabi Investment Authority, believes that 80% of the difference between the US and Chinese stock market performances can be accounted for by those buybacks.
Separately, in a presentation to the John Mauldin conference in recent weeks, Dave Rosenberg highlighted that USD 4 trillion had been added to the Federal reserve’s balance sheet since 2009, which coincided with the issuance of an additional USD 4 trillion in corporate debts, which, funnily enough, also translated into USD 4 trillion of share buybacks. Funny that. (Though our longer standing readers should not be surprised)
Pessimism in China underpins attractions
Turning to the issue of valuations, high levels of pessimism are reflected in valuations for the MSCI China A shares. Remember that A shares are those companies quoted on stock markets within China, and which only recently have become accessible, to some extent, by investors outside China.
In an ideal world you want to buy when short term pessimism veils longer term attractions.
Valuations of China’s A shares are down by about 25% over the last year. Interestingly, this has very little to do with trade wars with the US. The reason is primarily deleveraging, which basically means that China’s economy had become too dependent on debt to support economic growth, and the central government has been trying to bring this under control as it moves the emphasis of the economy from quantity to quality of growth. In the long run this is very sensible, but in the short run it has dampened enthusiasm for domestic shares by domestic Chinese investors.
To illustrate the lack of impact of trade war, only 2.5% of the turnover for non-financial A shares is sourced directly from the United States.
These A shares are listed on the domestic Shenzhen and Shanghai stock exchanges, and total around 3,000 individual companies. Of these, around 1,500 can now be accessed through what is called the stock connect scheme.
Perhaps more importantly for investors, approximately half of the A shares are smaller and medium-sized companies, in particular giving an exposure to China’s new economy in the areas of consumption, technology, and innovation. China enjoys a very rich digital ecosystem (for example see blog on Greater Bay Area), populated by a huge number of highly qualified specialists, dwarfing those available in the US.
The emerging market team at Allianz say they are often asked when is the right time to buy Chinese A shares. There is no simple answer. But there are occasions when valuations and sentiment reflect all the bad news, and that feels like now.
A story just starting
We highlighted previously how the MSCI emerging markets index is evolving to allow for the inclusion of Chinese A shares. But this is only a start.
China is almost certain to become the largest economy in the world, and a global leader in many areas. Yet most investor portfolios allocate only a fraction, if anything, to China versus exposure to the US.
For example, when I have looked at Gold Member portfolios over the last year, I have noticed some extremely successful exposures to the US, particularly through global funds with a heavy weighting to the US, and technology in particular.
The latter will have to evolve in coming years if you are to take advantage of the opportunities in China, and where global institutional investors will also consistently increase allocations to China, and underpin prices.
By the end of this year Chinese A shares will account for 3.3% of the MSCI emerging market index. But as I said earlier, this is just the beginning of the longer-term story, and it is believed that this could go much closer to 30% in the years ahead. Smarter investors will be gradually building their exposure ahead of this.
China versus US – relative market attractions
In the short term the Chinese stock market looks cheap and investor sentiment is poor. Yet it is not difficult to visualise substantial scope for innovation and growth taking a longer view.
In contrast, the US stock market is at valuation extremes rarely exceeded, and there is widespread complacency about both equity and bond markets.
And, of course, whereas leadership the United States is always at the mercy of the electoral cycle, the Chinese leadership benefits from a much longer-term focus, and considerable control from the centre.
In summary, of course China has numerous challenges, particularly around the issue of debt, but it’s leadership, with its long-term focus, is well placed to handle this.
A quick glance at the potential
Despite the economic slowdown in China in 2018, the fundamental logic of investing in China for its growth prospects remained intact, for many years to come. In particular it reflects a fundamental change in the attitudes of younger Chinese, but also the changing demographic balance, technology advances, and a very focussed and settled leadership.
To illustrate how far China has yet to advance, overseas travel is still in its early stages - despite the fact that you may have observed much larger numbers of Chinese in your own travels, whether in the Outer Hebrides or on safari in Africa. For example, only 9% of Chinese citizens own passports.
Healthcare is also a growth area, as it is in so many parts of the world. But the catch-up potential in China is particularly stark.
For example, annual personal healthcare expenditure in China is just USD 426, whereas in the US the equivalent number is USD 9,536.
There is also much innovation in consumer technology, in particular in the area of foreign substitution.
For example, in 2008, 90% of smart phones sold in China were from three foreign brands. Now eight of the top 10 smartphone brands are Chinese, with Huawei leading the pack. Perhaps no surprise then that they are the target of President Trump.
“The Trump Dividend” for China
Of course, there are areas where China remains dependent on foreign imports, particularly for components. Hence Trump initiating an outright ban on some US companies supplying Huawei. Nonetheless, there is another (positive) side to this.
Huawei have already highlighted that they had been planning substitution of components for a number of years. Of course, there might be an element of bluff here, talking positively to calm the nerves of their investors and buyers. Yet it is absolutely clear that the action by Trump will accelerate innovation by Chinese companies. This is not exactly the result he would have wanted, and yet it is inevitable.
This in turn will then pave the way for new Chinese manufacturers to enter the very international markets which the US currently regards as its own.
It will be a steep learning curve for Chinese companies in some areas, such as semiconductors, robotics, and commercial aircraft.  But you can be certain you will see a new urgency in these areas in China in the weeks, months, and years ahead. The race for technological supremacy is about to speed up.
In summary…
There does appear to be a cheap opportunity to buy China, and an exposure to A shares looks particularly interesting. For those who might be feeling a tad cautious right now (perfectly understandable), building an exposure month by month over an extended period is ideal to exploit this opportunity. In the next fortnight we will produce some more detail on funds with a greater exposure to A shares.


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