Market Thinking

making sense of the narrative

China tells Pompeo, “I know what you did last Summer”

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Today’s announcements from China need to be seen in the context of the last two years of steadily intensifying interference in Chinese affairs by the US as part of the new Cold War. At the 13th National People’s Congress we see the first real signs of Chinese push-back, Investors need to be aware that the simplistic “US good, China bad” narrative that has been promoted is highly politicised, just as the ‘China is just another emerging market that can’t cope without the US consumer’ one was. Not least because, globalisation champions are going to get caught in the crossfire.

As noted in recent commentary, the escalation of anti Chinese rhetoric coming from Washington in the last few weeks has been quite extra-ordinary and while it is perhaps understandable ahead of a Presidential Election, it nevertheless presents a clear medium term risk to investors. Today’s announcement on Security legislation for Hong Kong is being presented by the US and ‘pro democracy groups’ in Hong Kong as an end to One Country two systems, whereas as this editorial from Global Times https://www.globaltimes.cn//content/1189137.shtml points out, the Chinese view it as a way of protecting the system and in particular prevent it from being exploited so as to undermine the security of both Hong Kong and the mainland. The Global Times is the tabloid voice of the CCP and the significance of the editorial is that it is not only clear that the CCP believes the US to have been interfering in Chinese national affairs, but that it is publicly saying that it thinks so. This is a shot across the bows of Mike Pompeo. The are saying we know what you did last summer, but now you know we know and we want the rest of the world to know that we know that you know that we know…

The initial skirmishes of the trade war got most of the attention but also revealed several unpalatable truths. First, as with the British in the 19th century, the trade deficit between the US and China reflects the fact that there is not much that China has to, or indeed wants to, import from the US beyond some basic commodities. Second, that the majority of the trade deficit arises from US corporations such as Apple having moved all their assembly lines – and by extension jobs – to Asia over the last decade. The west has outsourced its manufacturing such that tariffs will simply increase the costs of goods to US consumers since there is little or no domestic – and hence non-tariff – competition. The third unpalatable truth for the US is that unlike its previous competitors in international trade, South Korea, Germany or Japan, the US has no standing army in place to ensure that the relevant foreign government ‘understands what is in their best interests’.

Even more unpalatable however was the announcement in 2015 of the strategic initiatives ‘One Belt One Road’ and  ‘Made in China 2025’ and the realisation that China was already ahead of the US in terms of  technology in a number of areas such as AI, facial recognition, robotics, the internet of things and 5G as well as starting to dominate in areas like supercomputers, genetics and material sciences. The desire to contain China thus began in earnest, first under the Obama administration with its ‘Pivot to Asia’ strategy back in 2015 and subsequently under the Trump administration – even if the latter suffused its intentions in a wall of rhetoric about trade tariffs. 

Nevertheless, western voters and by extension many international investors were encouraged to believe China was still just another emerging market, an export-led economy that couldn’t survive without the US consumer. But this was a caricature of the China of 15 years earlier and anyone investing on this basis lost a lot of money. Then they were told/believed that it was a financial bubble with Ghost Cities and bad banks that was only kept propped up by the US consumer (again) and by official lying about statistics. But that in turn was a caricature of the China of 10 years ago. The reality is that in the last 5 years, China has become all about the domestic economy and particularly about the relatively unleveraged domestic consumer. None of this is secret, the CCP set it out in their five year plans and yet it seems to be ignored, perhaps willfully, by analysts looking at China from the west. Ignoring the law of big numbers, they present China’s slowdown in growth from 9% to 7% as a slump, when in fact, as every global corporation knew, it was the chief, often the only, driver to growth. Investing in China has undoubtedly been a challenge, but that is because of the gyrations in the risk premium, there has been no doubt about the strength of the cashflows and the underlying economic growth – at least with hindsight.

The US approach to date has been to try and disrupt China rather than compete with it and we have no doubt that this has included tactics to try to assemble a coalition of ‘allies’ in the region to support Team USA. These tactics have included ‘freedom of navigation’ patrols by the US navy in the South China Sea, demonstrations of ‘support’, including selling weapons, to countries like Philippines or, again just this week, Taiwan, and high levels of rhetoric to agitate the situation in Hong Kong, As we noted a year or so ago, the actions of Mario Rubio and others in channeling HK protests against a proposed extradition law into a ‘Freedom and Democracy’ campaign in the style of a classic US State Department ‘colour revolution’, not only helped escalate the troubles Hong Kong faced last summer, but also ended up with the US passing the Hong Kong Freedom and Democracy Bill at the end of last year. In this bill, US politicians awarded themselves the right to sit in judgement upon China’s adherence to America’s rules. And all this was Before Covid (BC).

The announcements this week therefore need to be set against this background, first in the reason we suspect China made them and second in the likely way they will be presented to the west by the propagandists. Investors need to make their own judgements.

In our view, China announcing that it will in effect establish the security law that HK has so far failed to establish is not only a reflection of the fact that it fears losing its pro Beijing majority in September, but is also a shot across the bows of the US. While the content is unlikely to be much different from the article 23 that the Legco was supposed to have put in place anyway, it is the emphasis on foreign interference that is important, certainly in the light of what is likely to be an increasingly fervid US Presidential Campaign where “Blame China not Trump’ is the message from one side and “We are tougher on China than you are’ is the message on the other. There is no doubt in our minds that the legitimate protests of a year ago in Hong Kong were hijacked by vested interests from outside, looking to advance their own causes, principally by making trouble for China. China is saying no more.

Interesting that, as we suggested a few days ago, the US now looks to be going after the Chinese ADRs, with the Senate announcing a bill requiring US listed companies to adhere to US accounting standards, also requiring them to disclose whether they are owned or controlled by a foreign government. This is all perfectly legitimate, markets eager for listing fees had essentially allowed China an exception, but is clearly part of the weaponising of the US financial markets in the new cold war. It has already led to Baidu talking about delisting and others are likely to follow suit – possibly re-listing in Hong Kong (which would be a rare piece of good news for Hong Kong.) It also paves the way for something we discussed earlier in the week, imposing US foreign policy into ESG scoring. Declaring something bad governance or unethical and thus forcing divestment by the ESG funds is an obvious way to leverage pressure and while the ESG industry is nowhere near as large as some of its proponents claim (there is a big difference in the total AUM of companies vowing to follow ESG principles and companies actually run on that basis) it is nevertheless meaningful. It is however a big issue for investors if your investable universe is now going to be set by the US State Department.

The point of all this for investors is to understand the narrative being presented and try and anticipate both the actions and the reactions. They may have now realised that the previous narrative of China being just another emerging market dependent on the US consumers was not only incorrect but in fact more of the opposite, western corporations have become increasingly dependent on the Chinese consumer.  In the same way they should consider that far from China being indebted households with a bankrupt shadow banking system, that description is far more readily applied back to the west. The US administration seems to have forgotten, but investors should certainly remember, that a physical bi-lateral trade deficit often has an offsetting services surplus and while the US mainly sells agricultural products plus a bit of aerospace to China, China runs a large services deficit. In 2017, China was running a deficit on tourism and travel of $27bn a month at one point. If you tell them to stay at home, they probably will.

Investors need to start thinking about punch and counter-punch. The harassment of Wuawei has not, so far, been retaliated against, but global supply chain companies such as Apple must be becoming extremely nervous. The ADRs may come back to Hong Kong, which may help international investors looking to get exposure to China growth, but then in turn it is entirely possible that a lot of them will find themselves unable to invest for (US determined) ESG reasons. Meanwhile, US companies relying on the goodwill and licensing of the Chinese such as payments companies must be nervous and the risks to the US casino companies like Las Vegas Sands must have risen significantly. 

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