Despite the tariffs rhetoric being ratcheted up in recent weeks, we see limited impact on the long-term growth stories of portfolio companies.
Short timeline of events
March 9, 2018 – The US announces a global tax on steel imports at 25% and aluminum imports at 10%. As China accounts for almost 50% of the world’s steel production and is the world’s largest steel exporter, it calls the tariffs “a serious attack on the normal international trade order”.
Exhibit 1: China accounts for almost 50% of the world’s steel production
Source: World Steel Association.
April 2, 2018 – China retaliates by hitting the US with tariffs on US$3 billion worth of exports that include 128 products.
April 3-4, 2018 – The US proposes a 25% tax on $50 billion worth of Chinese exports. The Chinese government mirrors this proposal, announcing a 25% tariff on $50 billion worth of US products.
Late April – Early May 2018 – US and China hold talks and tariff plans are put on hold.
May 29, 2018 – The White House revives the 25% tariff threat on $50 billion worth of Chinese goods.
June 15, 2018 – President Trump confirms the plan to slap punitive tariffs on $34 billion worth of Chinese exports to the US that is to take effect on July 6th (the effective date of tariffs on the remaining US$16 billion will be announced at a later date). China’s Ministry of Commerce announced that “all the previous agreements reached through talks will become invalid” and hit back with its own retaliatory tariffs covering $34 billion in imports from the US.
June 19, 2018 – Trump directs US Trade Representative Robert Lighthizer to identify an additional US$200 billion worth of Chinese goods on which to impose tariffs should China go through with its reciprocal tariffs.
Exhibit 2: Timeline of US-China trade war
Source: Bloomberg, Press search
The issues at stake
1. The large bilateral trade imbalance
According to the US Census Bureau, last year the US ran a US$335 billion trade deficit in goods and services with China, comprising the bulk of its US$566 billion trade deficit overall. This was the largest deficit since 2008 and President Trump has since come under pressure to rectify the situation.
2. Technology, intellectual property and fair competition
Beijing’s “Made in China 2025” campaign, an ambitious scheme for the Chinese state to back strategically-important industries such as automation and AI, is at the center of the trade dispute. The Trump administration contends that programs such as “Made in China 2025” are China’s way of “seizing economic leadership in advanced technology” and its policies include “coerce[ing] American companies into transferring their technology and intellectual property to domestic Chinese enterprises.”
With the US mid-term elections coming up in November, Trump has intensified his stance on issues like immigration and trade policies. Being tough on China and getting a better “deal” for America is rhetoric that will play well before his electorate and improve voter support. However, this could very well backfire in rural states, a stronghold of the Republican base, as farmers of soybeans and other commodities will be hard hit by China’s counter-tariffs. It is not in the current Chinese DNA to kowtow to foreigners so President Trump might have to keep escalating to appear stronger, with unintended consequences.
The biggest loser
“It’s clear that China does have much more to lose”. Those are the words of Peter Navarro, a senior White House trade advisor. But how true is that statement? All sorts of estimates have been posited about the likely negative implications on the Chinese economy.
It seems that the immediate impact on Chinese growth will be muted. A 25% tariff on US$50 billion of Chinese exports is expected to shave off just 0.1% of GDP. For an economy the size of China’s that is growing at around 6.5% year-on-year, this is a negligible number. Of course, if China’s reciprocal tariffs trigger further escalation from the US, this number will increase significantly. Also adding to the uncertainty is what effect the tit-for-tat dialogue will have on investment and business confidence as buyers adopt a “wait and see” approach.
The integration of supply chains also means that the impact to China is going to be less than what the headline number suggests. Fortunately, or unfortunately, the pain will be spread out across many geographies, as the Non-China portion of value-add to final exports is (in some industries) significant, as shown in Exhibit 3. Ironically, US companies will also be impacted as 37% of US imports from China are intermediate inputs, which directly impact the competitiveness of US companies in global markets.
Exhibit 3: Value-added structure of U.S. imports from China, in billions of U.S. dollars, 2014
Source: Brookings Institute.
Many domestic industries rely on imported parts or intermediate inputs that have no readily available US substitute. As a result, companies have to make the decision to either absorb a lower profit margin or pass on the burden of cost to its consumers and face lowered demand for their goods. Exhibit 4 highlights the top US imports from China based on 2017 values that will be affected by the upcoming tariffs.
Exhibit 4: US imports from Chinese of tariff-targeted products
Source: Financial Times.
From an economic standpoint, the general consensus is that trade wars are always sub-optimal. Disrupting supply chains hurts not just China, but US companies as well as third countries that become collateral damage. A large share of Chinese exports come from foreign value-added. Based on the OECD’s Trade in Value Added database, Taiwan, Malaysia and South Korea are the countries that are expected to be hardest hit should Chinese exports take a dive . Interconnected supply chains also mean that negative sentiment will have a ripple effect throughout the global economy. We expect this impact to be worse on the public markets than on the real economy.
From a political and strategic standpoint, taking a hardline stance against China only serves to undermine America’s role as a trustworthy partner among other trading nations. We saw that after President Trump withdrew from the Trans Pacific Partnership (TPP) in 2017, the 11 remaining nations in the TPP forged ahead with a revised agreement which was signed in 2018. We expect new trade partnerships in the region to form if Trump’s policymaking leaves a vacuum which China is more than happy to fill. As we have seen time and time again, China is in a fiscal position to offer incentives to foster economic ties with its neighbors, furthering its role as an attractive economic and geo-political partner.
China understands that while it must retaliate against any provocations from the US, it is in its best interests to pick its battles carefully and ensure that any fallout will not deter it from going down the path of reform and opening up. A senior Chinese government official was quoted in the South China Morning Post as saying, “The message from the top is that ‘nothing can stop China from opening up. It is particularly important for 2018 when China is celebrating the 40th anniversary of its ‘reform and opening up’ policy.” This kind of restraint shown by the Chinese would not be possible if Xi was not fully in charge and capable of pushing through tough policies via a streamlined top-down approach.
China’s “national will”
As we outlined in the Annual Meeting, China is one of the few countries that can exercise a “national will”. Policymakers in Beijing desperately want to avoid a repeat of the stock market turbulence of June 2015, and therefore are willing and able to adjust monetary policy to keep the economy stable. We are already seeing this happen in response to the latest trade spat.
On June 18, 2018, the People’s Bank of China (PBOC) lent 200 billion yuan to financial institutions using its medium-term lending (MLF) facility to ensure domestic demand holds up in the face of these trade headwinds. Just a week later the central bank reduced the reserve ratio requirement (RRR) of Chinese banks by 0.5% (effective July 5, 2018), unleashing a further 700 billion yuan of liquidity into the system. This will help banks boost credit supply to smaller companies.
Furthermore, as part of the reforms that were announced during the National People’s Congress in March, Chinese authorities have cut individual income taxes. While this was not in direct response to recent trade issues, this will be a welcome boost to domestic consumption. It is estimated that the tax cut could affect 80% of the 340 million urban registered workers and potentially boosting consumption by US$19 billion, equivalent to 0.15% GDP. These are just a few examples of how Chinese policymakers can take concrete steps to bolster demand and direct money to parts of the economy where it is needed.
Another potential lever at the disposal of the PBoC is managing the RMB’s daily “fix rate” to the greenback to make existing exports more competitive. The US$250 billion worth of exports on which the tariffs are proposed is equal to 2.2% of GDP. Unsurprisingly, the Chinese currency has consistently weakened over the past month (depreciating around 3% in June). This has already offset the actual impact of the tariffs and can be used to help ameliorate further tariff announcements.
Additionally, amid the media sensationalism, this US$50 billion number is mentioned as though the whole amount of exports will magically evaporate. This is not the case. The US no longer makes a sizeable chunk of certain goods, including electronics such as mobile phones.
Exhibit 5: Top 10 China exporting sectors to the US, 2017
Source: J.P. Morgan
As indicated in Exhibit 5, the bulk of China’s exports to the US is in the tech and machinery space. With an estimated US$72 billion worth of mobile phones  being exported from China, even if tariffs go up, the vast majority of these shipments will still find their way into the US.
How does this affect private equity in Asia?
Although Trump has stated that he will not impose additional restrictions on Chinese investments, he could still restrict Chinese acquisitions in high-tech sectors and call for stricter controls for transfers of intellectual property. If China responds in kind, this could be even more of a hit to the US as US companies have an estimated US$260 billion of FDI invested in China, almost double the US$140 billion that Chinese companies have of FDI in the US .
As conditions between the US and China deteriorate, Chinese tech companies are looking elsewhere to source components. Their destination of choice? Israel. At least six Chinese tech companies have discussed investment opportunities with Israeli microchip makers since March. Chinese companies are also shoring up domestic supply chains to reduce their reliance on the US. Alibaba recently acquired microchip supplier Hangzhou C-SKY Microsystems, while Baidu and Huawei have both reportedly poured money into developing their own chips.
Exhibit 6: The majority of Axiom’s investments are in the Consumer, Healthcare and Tech sectors
As Exhibit 6 illustrates, Axiom’s managers have been astute in the last few years, investing in sectors that will benefit from a China that emphasizes greater self-reliance for key technological inputs, and focusing on the three sectors highlighted in blue. As these are less impacted by global trade, we feel that this is the most defensible play given today’s uncertain market.
Though the risk of a trade war is looking increasingly likely at this stage, there is a possibility that both the US and China choose to back down from further escalation. We have seen this play out twice before in 1994 and 1996 where tariffs and retaliatory tariffs were called off. The tariffs went into effect July 6, 2018 although both sides now have a three-week window for further negotiations. Even if the trade balance issue is resolved in the near-term, China’s rising dominance and what this means for US/China relations as a whole remains a looming issue.
We like to apply Deng Xiaoping’s wisdom to the current situation. He once opined that one should “hide brightness, nourish obscurity”. Essentially saying that in order to prosper, you should fly under the radar. In this vein, big, foreign, headline-grabbing deals are going to be attracting attention of policymakers in both the US and China. Axiom’s strategy has always focused on the fast-growing domestic sectors which are driven by non-trade or politically related factors such as the incidence of disease (healthcare), rising standards of living (consumption) and greater familiarity and propensity to utilize technology in our everyday lives (IT). We continue to focus on doing local deals and tapping into opportunities that others may not even be aware exist.
 “Notice of Determination and Request for Public Comment Concerning Proposed Determination of Action Pursuant to Section 301: China’s Acts, Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation”, Office of the United States Trade Representative, April 3, 2018.
 “China: At the edge of a trade war”, J.P. Morgan, June 18, 2018.
 “Why a trade war with China would hurt the U.S. and its allies, too”, Brookings Institute, April 4, 2018.
 “Global Insight: Trade War, Day 1 – Forecasting the Casualties”, Bloomberg Intelligence, June 18, 2018.
 “Trump may pull the trigger on tariffs but China will pick its battles, sources say,” South China Morning Post, July 5, 2018.
 “China eases policy to offset trade risk and liquidity concerns,” Citi Asia Strategy Bulletin, June 19, 2018.
 “U.S. –China trade tension,” J.P. Morgan, May 21, 2018.