Historically, Americans have been very pro-trade, however, a majority of citizens agree with the US President’s views about moving toward deglobalisation.
China 2025 is perceived as an existential threat to US commercial and technological leadership. This raises the risk that the Trump administration could conclude that its best response is to decouple much of the US supply chain from China.
As discussed in this paper from Epoch Investment Partners, penned by CEO and co-CIO Bill Priest and Managing Director of Global Portfolio Management Kevin Hebner, such a move toward deglobalisation would prove acutely negative for corporate margins and earnings.
US President Trump has been an unabashed trade hawk for decades. He has called for protectionist measures since at least 1989 when he declared “I’m not afraid of a trade war,” presaging his more recent exhortation that “trade wars are good, and easy to win.”
Historically, Americans have been very pro-trade. Today, however, a majority of citizens agree with the US President’s views, especially when it comes to dealing with its new rival, China. It is no longer just about jobs. The US is worried about China’s growing commercial and technological clout, with both sides vying for dominance over new technologies that will determine the economic balance of power in the 21st century.
China has changed the terms of engagement since President Xi’s ascension in 2012. While his predecessors emphasised the slogan “peaceful rise,” President Xi has been far more assertive than anything seen since the days of Mao Zedong.
This “new era,” as Chinese officials have taken to calling it, has celebrated and entrenched the state’s leading role in the modern economy. The key reason why tensions have ramped up recently is “Made in China 2025”, Beijing’s aggressive blueprint for dominating the tech industries of the future, including robotics, biomedicine, renewable energy, aerospace, communications equipment, new materials and artificial intelligence (AI).
Made in China 2025
US policy makers have been startled by the plan’s focus on “indigenous innovation” and the Maoist calls for “self-reliance”, aspiring to achieve self-sufficiency through domestic “secure and controllable” technology and import substitution. Publicly proclaiming the aim of dominating critical high-tech industries has confirmed suspicions in DC that China is not looking for a win-win in trade relations.
It is difficult to understand why Beijing didn’t foresee how hostilely such a massive and pivotal state-led program would be received in America. Made in China 2025 is an ambitious scheme that directs huge state subsidies at key new tech sectors that China wishes to dominate.
From America’s perspective, two aspects of the blueprint are particularly worrisome: first, its reaffirmation of the government’s central role in economic planning; and second, its focus on import substitution.
Made in China 2025 expressly calls for China to achieve 70-80% self-sufficiency in a wide range of critical, tech-heavy industries. Achieving such brazen market share targets clearly requires enormous government support, much of which occurs through a web of opaque subsidies. Firms associated with Made in China 2025 are provided with extensive financial assistance through a multitude of state-directed investment funds.
Although it is challenging to find a comprehensive listing of all sources, it is possible that total support could exceed an eye-popping $1 trillion. The US Chamber of Commerce estimated that the Chinese government plans to spend $161billion by 2025 to develop the semiconductor sector. That is a huge sum of money, and it only refers to one industry.
All ten of the sectors targeted by China 2025 are viewed as key to future economic growth by both China and the US. However, the truly breathtaking innovations are occurring in fields directly affected by AI.
To illustrate, earlier this year both PwC and McKinsey estimated that, by 2030, world GDP could increase by around $15 trillion (or 14%) purely because of AI, with China being the primary beneficiary (receiving about 45% of the total gain). This makes AI the biggest commercial opportunity in today’s dynamic economy and means the stakes are unprecedentedly high.
Mercantilism: a core feature
Mercantilism is a core feature of the Chinese economic system. Imports of manufactured goods from the US represent less than 1% of GDP.
There are also severe restrictions on foreign direct investment. According to the Organization for Economic Cooperation and Development, China maintains one of the most restrictive investment regimes with only a few countries, such as Saudi Arabia, ranking worse. Many sectors have rigid foreign equity restrictions or joint venture requirements. These restrictions either block opportunities, or, in some cases, create a de facto technology transfer requirement to the Chinese partner as a pre-condition for market access.
Data compiled by Global Trade Alert (an independent think-tank based in the UK) demonstrates that China has implemented a distressingly large number of mercantilist measures over the last decade (figure one). While the US and other countries have also exhibited a proclivity toward protectionism, China is in a league of its own among large economies.
Finally, the US has unquestionably been the world leader in the commercialisation of the internet.
However, no US website ranks in the top 25 most visited in China. This is a direct result of China having banned, blocked or placed high restrictions on sites such as Google, YouTube, Facebook, Instagram, WhatsApp, Snapchat, Twitter, Pinterest, Flickr, Tumblr, Dropbox, the New York Times, Bloomberg and the Wall Street Journal.
China’s mercantilist behaviour has undermined political support in the US for free trade and openness. There has been a ramping up of anti-trade rhetoric, the WTO appears increasingly irrelevant, and the US has withdrawn from the Trans-Pacific Partnership process.
If the trend continues, we could end up with a segmented world trading system instead of a global one, an outcome that would be lose-lose.
The US response
During the last couple of decades, America’s approach to China has been founded on a belief in political and economic integration and convergence. However, by celebrating and entrenching the state’s leading role in the industries of the future, President Xi and his “new era” have demonstrated that convergence was never their goal.
The Trump administration has adopted an aggressive stance, demanding three key changes. First, that China jettisons the mercantilist web of rules that have systemically protected and lavishly subsidised companies in numerous sectors throughout the economy.
Next, that China ceases its chronic practice of purloining US companies’ trade secrets (via forced technology transfer, state-sponsored cyber theft, and corporate acquisitions).
Finally, that Beijing fully embrace the principles of reciprocity and full market access for US businesses operating in or exporting to China.
In October, Vice President Pence delivered a remarkable, 40-minute broadside against China that justifiably received an enormous amount of attention. The Financial Times argued this speech was the most important event of 2018. In surprisingly blunt and strident terms, Pence accused China of bullying American companies and stealing their technology and Intellectual Property (IP).
He concluded that it is up to China to avoid a Cold War, demanding concessions on several issues, including its rampant IP theft, forced technology transfer, and restricted access to Chinese markets.
While Pence’s speech has received significant attention, the craftsman behind US trade policy, and chief China critic, is Robert Lighthizer, Trump’s US Trade Representative.
Lighthizer makes a compelling case that China’s economic and political system is fundamentally incompatible with our conception of free trade rules and has been particularly critical of the systemic non-compliance practiced by China for decades.
With forced technology transfer, unfair licensing requirements, corporate acquisitions and government-backed cyber theft as primary sticking points in the ongoing negotiations between Presidents Xi and Trump, one does not have to be a trade lawyer to realise how difficult it will be to obtain a verifiable agreement that both can bring home and declare victory. Effective 24 September 2018, the US imposed tariffs on $200 billion of Chinese imports.
Ongoing negotiations, with a soft deadline of 1 March 2019, will determine if the tariff rate is raised from 10% to 25%, and if tariffs will be applied to additional imports from China.
The global supply chain unravels
It has been just over a decade since Thomas Friedman’s “The World Is Flat” painted globalisation as a seemingly unstoppable trend. It may have marked globalisation’s peak. During the past few years global supply chains have begun to buckle, with the world’s two giant economies clearly de-coupling.
If the global supply-chain does bifurcate, with one part centred around the US and the other around China, which sectors would be most affected?
Ground zero is likely to be all ten sectors that are targeted by China 2025, especially where sensitive technologies are involved. Among the hardest hit industries would be tech hardware, especially semiconductors, with tech software and services being less directly affected. Other exposed industries include capital goods, and possibly autos, as well as certain consumer durables and chemical/commodity sectors.
Still, a full chasm between the two countries seems improbable, with the possibility that energy and agricultural commodities could even become beneficiaries of the new trade architecture.
As trade tensions mount, what countries are most likely to benefit by stepping into the void left by China?
While relatively little would return to the US, it is feasible that some high-end manufacturers could move to Korea, Taiwan, Japan and Singapore, while the low-end manufacturing could shift to ASEAN countries, and possibly Mexico.
Even if a relatively small percentage of existing production were relocated, or if capacity expansions began to favour these destinations, the local impact could be highly significant.
Foreign direct investment (FDI) has been flowing solidly into the ASEAN region over the last decade, even as FDI into China has started to moderate. This suggests that the marginal relocation process is well underway, with Vietnam, Malaysia and Thailand appearing best positioned to attract significant FDI inflows.
Manufacturing margins under pressure in 2019
If global supply chains do in fact bifurcate, what is the likely impact on corporate margins and earnings?
One channel that hasn’t received sufficient attention concerns the impact of overcapacity in China 2025 sectors. Whenever countries undertake overly ambitious central planning exercises, excess capacity inevitability results.
This occurred earlier in China’s development when it built-out its heavy industry capabilities (steel, cement, petrochemicals) and this time around is likely to prove even more wasteful.
Such excess capacity will probably drive down margins and profitability in most China 2025 industries, and not just in China, but globally.
An even more worrisome channel concerns unwinding the decades of progress that has been made with globalisation. International trade accelerated from 1990, following the fall of the Berlin Wall, and was then turbo-charged at the turn of the century when China entered the World Trade Organisation (WTO). A key part of this acceleration was, over a period of many years, putting in place the complex global supply chains that exist today, a process that helped drive a dramatic increase in manufacturing margins (figure two).
This suggests the recent turn toward protectionism is likely to be particularly negative for sectors such as tech hardware, semiconductors, industrial capital goods and some consumer cyclicals
Moreover, the labour cost savings from locating production abroad (largely in China) are estimated to have accounted for about one-fifth of the increase in manufacturing margins since 2000.
However, this factor is likely fully played out and will probably be at least partially reversed during the next couple years. A bifurcation that results in a much less efficient global supply chain would cause additional damage to margins. This is why we believe the peak in manufacturing margins is now well behind us.
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