Will the Trade War Between the U.S. and China Grow Into Cold War II? What That Might Mean For Investors?

This commentary will briefly outline aggressive trade and military actions taken by the United States that will likely make resolving trade issues with China more difficult. The headline from an op-ed commentary by Walter Russell Mead in The Wall Street Journal—“Did Cold War II Breakout Again?” summarizes the potential outcome.

The Non-Market Clause
The recently completed negotiations to replace NAFTA gave investors an initial sense of optimism that the trade war with China might be resolved in the not too distant future. In our view, that optimism may be misplaced. The USMC trade agreement deals with non-market countries – assumed primarily to be China. Article 32.10 in that agreement states – “entry by any party into a free trade agreement with a non-market country, shall allow the other parties to terminate this agreement on six-month notice and replace this agreement with an agreement between them (bilateral agreement).” In the future, the administration may attempt to insert this “non-market economy” clause in other future bilateral trade agreements. At this time, the U.S. and the European Union so far refuse to classify China as a “market economy” based on the W.T.O. Framework.

Broadening Bilateral Trade Agreements to Include the “Non-Market Economy” Clause
This provision may alter the approach used by the administration in its trade negotiations with Europe and Japan. While China has already signed 16 bilateral trade deals with other countries, none exist with Canada, Mexico, Japan, or Europe. The New York Times recently quoted Larry Kudlow, the White House economic advisor – “we are talking to the European Union again, we are talking to Japan again, and we are moving to what I have characterized as a trade coalition of the willing to confront China.” After the confrontational tactics used initially by the administration with our trade partners, the odds seem long for future bilateral trade agreements to include the “non-market” clause.

Made in China 2025 Industrial Policy — Threat To U.S. Military Technology Lead
Rapidly expanding China’s technology prowess represents a key goal of “made in China 2025.” A minister from China’s Ministry of Industry and Information Technology described it as – “China’s economy is moving from high-speed development to high-quality growth.” From Washington’s view, China’s advanced capability will create a direct threat to the U.S. military’s technological superiority.
According to a report from The Council of Foreign Relations, in 2016, Chinese investors, venture capital funds and state-owned-enterprises poured more money into all stages of U.S. technology development than ever before (see Figure 1). On top of these investments, a 2015 F.B.I. survey reported that China was responsible for 95% of economic-espionage cases. At the same time, U.S. firms operating in China faced challenges from forced technology sharing to mandatory joint ventures.

Figure 2
At the same time, Gavekal Research shows China represents a large market for U.S. semi-conductor companies (see Figure 3). Any U.S. attempt to slow Chinese chip development will instead likely result in speeding up China’s efforts to build advanced semi-conductor production capability. With that, U.S. chip suppliers will face increased competition in both China and other markets.

Figure 3
Percentage of U.S semi-conductor sales in China 2017U.S. Policies to Suppress U.S. Technology Equipment and Intellectual Property “Exported” to China
Basic Change in U.S. Relationship with China
Most investors and observers focus on the trade war with China as simply that. Instead, the administration will likely use tariffs and trade negotiations as a means to revise our broad relationship with China. The following comment from the China institute of contemporary international relations supports this view — “China has to maintain strategic vigilance. The U.S. has fundamentally changed its strategy towards China and defined the latter as a rival.” If these concerns prove valid, it will create important implications for those providing sensitive products for the U.S. military and other industries such as communications.

Direct Policy Actions — Moving It from There
On October 5th, the Pentagon expressed concern that more focus must be paid to the security of its electronics supply chain. Beyond the Pentagon, there will also be focus on equipment made in China used for communications infrastructure. For example, Australia recently banned Chinese communications companies from supplying its fifth generation mobile infrastructure equipment. To move assembly of secure military and other products such as those used in communications away from China will not be easy and will likely prove to be costly. Investors should determine the strategies for those companies most exposed to shifting their supply chains to other and perhaps more costly locations. At the same time, companies will benefit if Chinese companies cannot compete for business such as in communications.

Direct Policy Actions — Moving It to Here
This month, Congress passed a defense bill, which in part will restrict China’s economic and military activity. For investors, this bill would tighten U.S national-security reviews of Chinese corporate deals. At the same time, it also increases control over which technologies U.S. companies can send abroad. For example, recently, the U.S. blocked the Chinese government’s attempt to buy Lattice Semiconductor Corporation using an American proxy. That company manufactures chips used in missile guidance and radar systems.

Can China Out-Wait the U.S.?
With the Asian sense of time, a more patient one than the American sense of now, China may simply try to wait out this administration. They may be missing the broader change in Washington’s views beyond that of the administration. Recent media reports suggest a growing consensus across party lines in confronting China. More specifically, The Economist quoted a democratic member of the Senate Foreign Relations Committee, Senator Coons of Delaware who said – “there’s a broader, more intense and ideological competition from China than I had appreciated.”

China’s One Belt One Road (O.B.O.R.) Initiative
What is it?
China’s $1 trillion O.B.O.R. infrastructure initiative includes investments in ports in the sub-continent of Asia, high speed railways in East Africa, and gas pipelines crossing Central Asia. This initiative may prove to be the largest broad foreign investment effort ever undertaken by one country.

U.S. Response—Overall Strategy
The impact of O.B.O.R. on these regions ultimately caused the U.S. to rethink part of its strategic defense planning. From the 2018 national defense strategy of the United States, the following two quotes summarize its conclusion. “Inter-state strategic competition, not terrorism, is now the primary concern in U.S. national security.” The following sentence in the opening of the next paragraph states--- “China is a strategic competitor using predatory economics to intimidate its neighbors while militarizing features in the South China Sea.” Investors should determine how this change could affect the mix of defense spending over the next decade.

U.S. Military Repositioning — A Small Name Change But A Big Strategic Change
To reflect its changing strategic approach to China, the U.S. renamed its former Pacific Command the Indo-Pacific Command. It broadens the responsibility of this command from the Western Pacific through the Straits of Malacca — a maritime choke point—into the Indian Ocean and then reaches the Western border of India (see Figure 4). In doing so, it meets some of the challenges created by China’s O.B.O.R. initiative. It will also deal with China’s growing “blue water” navy used to protect Chinese supply lines from Africa and the Middle East. As part of that effort, China opened its first foreign naval base in Djibouti, which sits on the Horn of Africa near the passageway to the Red Sea and Suez (Bab-El-Mandeb — another maritime choke point).

Figure 4The straits of Malacca – China crude oil supply linesSource: Sites.Tufts.Edu
Secretary of Defense Makes it Clear The U.S. focus on China’s O.B.O.R. Initiative
At the ceremony for the New Indo-Pacific Command, Secretary Of Defense Mattis commented – “for every state, sovereignty is respected, no matter its size and it’s a region open to investment and free, fair and reciprocal trade not bound by any nation’s predatory economics or threat of coercion, for the Indo-Pacific has many belts and many roads.” Obviously, the end of this sentence points to China and its O.B.O.R. initiative as the focus for expanding the U.S. naval command into the Indian Ocean.

Investment Conclusions
China
This commentary makes the point that investors should be alert that our changing relations with China go beyond simply trade issues. The uncertainty of these changes could result in unanticipated economic and political events that will influence financial markets. In the near term, the currently scheduled November meeting between Presidents Trump and Xi at the G20 summit in Argentina could moderate these concerns. More than likely, some new round of trade negotiations will result. No matter the outcome of potential future talks, China will need to find ways to reenergize what appears to be a slowing economy (see figure 5). We will let the experts forecast what steps China may take to stimulate growth. In our view, the unknowns facing investors in China will likely grow if we truly see a Cold War II develop between the U.S. and China.Figure 5
United States
With the current strength of the U.S. economy, any fallout from the trade and potential cold wars with China initially will remain modest. Towards the end of next year, however, economists call for a gradual economic slowing. The combination of potentially unresolved trade and cold war issues combined with a slowing economy could bring unanticipated economic and financial difficulties for the financial markets.
Overall
Our investment view remains unchanged despite the recent volatility in the equity markets. We look for the current economic momentum to carry further into 2019 than economic projections now suggest. We also expect monetary policy normalization will begin to bite towards the end of next year. With this combination of pluses and minuses, the power of Fed normalization polices will likely be the ultimate influence tempering the economy and financial markets. If so, investors will begin discounting this possibility sometime in the first half of 2019. This leads us to continue to recommend a diversified balanced portfolio of equities, short duration fixed income securities, and alternative investments.

Say It Again Sam: Our Quarterly Reminder
Increasing budget deficits and reducing trade deficits do not mix—will not work—without increased net U.S. national savings. Our continued and future low net national savings rate means, that the U.S. will remain dependent on foreign surplus savings to finance the rapidly growing U.S. budget deficit. These international surplus savings come primarily from earnings on trade sent to the United States--- the balance-of-trade deficit. Even if we could eliminate the balance of trade deficit with China, our overall balance of trade deficit with other countries will still grow, not shrink, in order to fund our growing budget deficit.

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