Investing for the next “Cold War” & Why It Won’t Be Like the Last One

It seems that the world’s largest economic relationship is headed for dramatic rupture, but for the foreseeable future there will be peril, opportunity and everything in between.

BEIJING – The U.S.-China relationship is unraveling at an alarming rate. Even allowing that much of the latest bluster should be seen as late-stage negotiating tactics in a trade deal that will likely still get done, the rising level of bad feeling will rapidly overwhelm whatever partial truce may actually get inked.

While the consensus building in Washington that China has done little to deserve its 2001 entry to the World Trade Organization, the Chinese narrative grows louder that America just wants to keep its most threatening rival down. Talk of a new “Cold War” is likely misleading, but the complex dynamics of this volatile relationship require some careful thinking by all investors.

In some ways, key differences are making this brewing conflict less dangerous than the Cold War that defined U.S.-Soviet relations for more than five decades.

• Ideology: China clearly wants to be treated like a serious global player but lacks the Soviet Union’s ambition to remake every country in its own image. While President Xi Jinping has propounded a vision of China’s mixed socialist market economy with a muscular role in global affairs, there are few signs of a Marxist-Leninist model that will ultimately sweep the world.
• Technology: It’s easy to forget how hard we tried to measure the size and strength of the Soviet economy. China’s is far larger, far more innovative and far more integrated with the flows of global trade and investment. China also is a more capable competitor, but our technological supply chains are far more interdependent.
• Military: The rapid increase in China’s defense spending bears watching, but it remains around a third of U.S. outlays. Its focus around areas of intense interest to the United States – including Taiwan and the South China Seas – continue to rise but it shows few signs of projecting power globally (yet).

This means that casual labels from the past are of little help in understanding the dynamics at work. Investors need to start thinking about a relationship where broad areas of common interest and cooperation will coexist with increasingly rancorous exchanges. 

There will be rising concerns over politics, human rights and regional flashpoints, but for now the engagement will largely play out over economic issues.

• We are headed for a world of more or less permanent tariffs on the bulk of U.S.-China trade. Even an agreement in Osaka at the end of the month that removes them for the time being will not allay investor fears that future tariffs are possible –- perhaps likely -- given the continued friction over Chinese state subsidies and U.S. technology concerns. 
• There will likely be further escalation that includes threatening and harassing each other’s investments. Unfair treatment of U.S. firms operating in China has been at the heart of Washington’s complaints around Beijing’s economic policy. Meanwhile, newly tightened rules around foreign investment in the United States target Chinese access to advanced U.S. technology and critical infrastructure.  
• We also seem headed toward a complex and uncertain battle around technological supply chains. Initial measures against Chinese telecom giants ZTE and Huawei have led to substantial disruptions of Western suppliers. Yet Washington’s pressure on allies to forswear Chinese suppliers for its sensitive telecom networks has triggered a mix of uncertainty and resentment. British chip designer ARM and Japan’s tech giant Panasonic stopped supplying Huawei to comply with U.S. requests, but in the long run it will be hard for governments and companies to avoid buying equipment that is less expensive and rapidly improving in quality.

Theories that we are headed toward a world divided into two trading blocs around China and the U.S. seem too simplistic, especially when the heart of the struggle encompasses dynamic technologies that are quick to move, analyze and store the rising flows of data now sweeping the world and reconfiguring economies and business models.

Meanwhile, Europe views China as far more of a trading partner and potential investor than a geo-strategic rival, which will make European leaders deeply reluctant to choose sides. Japan, the world’s fourth-largest economy, looks to be in an even tougher spot. Moreover, it’s hardly clear that China wants to sink happily into the leadership of a “Chinese” bloc. If its political ideology carries fewer global ambitions, its technological giants have unlimited aspirations.

And so, as always, investors will have to watch closely, think clearly and move nimbly as they search for returns in a world that will be far more complex than the late 20th century. The headlines make it seem that the world’s largest economic relationship is headed for dramatic rupture, but for the foreseeable future there will be peril, opportunity and everything in between. 

U.S.-CHINA MOST TRADED GOODSSOURCE: USTR, AS OF DECEMBER 31, 2018

U.S.-CHINA EXPORT EXPOSURESOURCE: BLOOMBERG, AS OF APRIL 30, 2019