These days it is hard to have a conversation about China without considering geopolitical risks. We are seeing a decoupling between China and the US on all fronts – COVID-19, geopolitics, trade and technology.
Pro-democracy protests and a national security law have brought uncertainty to Hong Kong and increased tensions between the US and China. But Hong Kong’s economy as a proportion of China’s total GDP has fallen from 18% in 1997 to less than 3% today (reflecting astonishing growth on the mainland rather than contraction of Hong Kong). Hong Kong has historically been the financial hub connecting mainland China with global financial markets. China uses Hong Kong’s currency, equity and debt markets to attract foreign capital, while many international companies use it as a base to expand into mainland China.
Hong Kong is only a small part of a much bigger issue between China and the US. Market consensus is now that Sino-US tensions will be a long-term headwind for all. A recent survey suggested two-thirds of Americans disapprove of China, making China an ideal target for both the Trump and Biden election playbooks. The rhetoric will likely intensify as the election nears.
Trade is potentially a separate issue. Both China and the US were hit hard by the coronavirus, so a temporary truce in trade is important for the recovery of their economies. Top officials from both sides reaffirmed the Phase One trade deal at a closed-door meeting in Hawaii. China is buying more American farming goods.
Among these we see a “technology cold war” as a major future risk for global investors. It might have far-reaching implications for industrial supply chains, technology companies and consumers everywhere. Our view on China remains constructive though.
Global supply chains have never been more integrated. For example, Tesla procures EV batteries from Korean and Japanese suppliers who import cobalt and graphite from China. Tesla then sells its final products globally. Can these supply chains be easily restructured? Given concerns over national security and supply chain reliability post COVID-19, some adjustments will take place, but we do not expect China to lose out in the process, as long as it continues to embrace globalization and innovation.
The evolution of a supply chain is a natural process driven by various factors, like cost efficiency, labour supply, supporting facilities or logistics to end-markets. Technological breakthroughs often require co-operation from everyone in the ecosystem. For instance, ASML, a Dutch semiconductor supplier, could not have made advances in manufacturing smaller components for smart devices without support from TSMC, a Taiwanese company. It can be difficult to quickly replace part of a supply chain without severe disruptions to all.
Earlier this year, the US government further restricted the supply of chips to Huawei, China’s leading telecoms equipment producer. No doubt this will pressure the company and its supply chain, but not to a full stop. Huawei has been adapting since tensions started two years ago. In addition to billions of dollars of annual R&D spend, they are working with domestic suppliers to develop substitute technology and products.
Take 5G base stations. Currently 85% of the components are procured from or can be replaced by non-US (mostly Chinese domestic) suppliers. For the remaining 15%, like the main controllers and the analogue-to-digital converters, they will be replaced by a new generation of Huawei’s products. Some of these alternatives might not perform as well as the US comparables but they do the job. The chart below shows how the supply chain for a 5G station can change:
Source: Cephei Capital
By the end of 2020, China’s 5G base stations will account for over 70% of the worldwide total. It will become the second country after South Korea to cover all major cities with 5G networks.
US sanctions may extend to other Chinese tech companies. Internet giants like Alibaba and Baidu buy graphic processing units from Nvidia to use in cloud computing and Artificial Intelligence technology. Alibaba say their AI-powered chatbot can already understand more than 90% of over 3.5 million daily customer queries, even detecting a customer’s emotion and alerting human customer service agents to intervene. This progress will be impacted if companies cannot source the most advanced chips.
US tech companies are no less impacted by losing large Chinese customers. Over 25% of Nvidia’s revenue
[1] comes from China. Without this, US companies may have to cut back R&D spending which is critical to maintain their global leadership.
The consequences of a technology cold war are negative for Chinese companies who depend on foreign technologies, as well as their suppliers globally. It is also bad news for consumers everywhere. Duplicate efforts usually mean higher prices. But there are winners. Local consumer brands gain from rising nationalism and domestic substitution. Higher sales allow them to invest in R&D and catch up to foreign brands. Domestic substitution is also happening in the high-tech industries.
Consumption upgrades, urbanization, digitalization, and financial reforms will continue to be the major growth drivers for the Chinese economy. None of these have changed; if anything, the Sino-US decoupling has accelerated reforms and technological independence in China.
In conclusions, rising tensions between China and the US are real and cannot be ignored. Whilst it is important to avoid companies that will lose, there are also many investment opportunities that gain from this.
[1] Source: Nvidia’s Fiscal 2020 Annual Report
Robin You, Senior Investment Analyst, Riscura
