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Prevailing Winds

The China Investment Dilemma – Part IV

How to Navigate a Tumultuous U.S.-China Relationship

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

At a time when passive and quantitative approaches to investing are in vogue, it seems almost anachronistic to discuss the impact of foreign policy on portfolio management. However, the growing tensions between the world’s two largest economic powers are impossible to ignore and will shape investment returns in new and unpredictable ways.

No silver bullet or magic formula will eliminate the risks from investing in China. Given the degree of risk and complexity, financial advisors and individual investors may want to use a fund manager with experience and knowledge in this area rather than grapple with these challenges alone.

For investors who do decide to venture into China, a disciplined approach to evaluating and managing risks is necessary. It involves assessing the risks of an investment along three vectors: macro, sectoral, and company-specific risks. After evaluating the risks, investors can assign a China risk premium that can be incorporated into the overall assessment of an investment’s merits. These risks must be carefully monitored for changes that would necessitate a reevaluation of the investment.

Develop an Understanding of the U.S.-China Relationship

It is unreasonable to expect that every investor will become an expert China observer, but an appreciation of the major dynamics of the relationship between the two countries is necessary. At a high level, the relationship is shaped by China’s growing challenge to the U.S. on the world stage, the imbalanced economic relationship between the two countries, and dissatisfaction in the U.S. with China’s political and economic reforms.

Armed with a better understanding of the relationship, investors will be better prepared to assess how these issues may come to affect their portfolio. For example, concerns about China’s growing challenge to the U.S. on the world stage are leading U.S. policymakers to take steps to restrict the growth of Chinese companies that are emerging as global competitors or are producing strategic technology. The imbalanced economic relationship between the two countries means that the U.S. is likely to continue using tariffs and other forms of economic pressure to gain greater access to the Chinese market. The widespread dissatisfaction with China’s political and economic reforms makes it more likely that a hardline approach toward China will prevail in Washington and that companies closely linked to the Chinese government will be exposed to punitive actions from the U.S. government.

Understanding the history of the bilateral relationship will also help illuminate the current state of affairs. The relationship is likely to be interspersed with periods of relative calm; indeed, the waxing and waning of tensions has been the pattern of U.S.-China relations since the founding of the People’s Republic of China, in 1949. The relationship is replete with periods of conflict and tension, including the Korean War, the Vietnam War, the Tiananmen Square massacre, the numerous Taiwan Straits crises, the Belgrade embassy bombing, the Hainan Island incident, Wang Lijun’s defection, Chen Guangcheng’s escape, and others. Knowledge of the many instances during which the relationship has been on the precipice of a breakdown provides much-needed context and perspective when evaluating current events.

Many of the twist and turns in U.S.-China relations over the past few years have been surprising. That the two countries were headed toward greater conflict and the main fault lines along which that conflict would unfold were well known to people with an understanding of the relationship, however. Investors who venture into China without this knowledge may be blindsided by foreseeable risks.

Identify Which Industries May Be More Exposed to U.S.-China Tensions

Some industries in China may be particularly exposed to risks, for two main reasons. The first is that some Chinese industries are more reliant than others on access to U.S. suppliers or customers. Whether through tariffs or market access restrictions, such as the Commerce Department’s Entity List, U.S. policymakers can affect the economic interests of Chinese industries dependent on U.S. imports or exports. Reflecting these risks, these industries experience greater market volatility during periods of tension between the two countries. A recent study found that Chinese companies that are more reliant on exports or imports from the U.S. experienced greater price volatility during periods of both positive and negative news related to the trade war.1

Figure 1 shows the correlation between various industries within the MSCI China Index and a barometer of trade tensions. Industries with a positive correlation are those that perform worse when tensions increase. These industries – semiconductors, durables, apparel, auto parts, hardware – tend to be export-focused or reliant on U.S. imports. More domestically focused industries – telecom services, utilities, energy, banking – are less affected by developments in the trade war.

Figure 1. Correlation between Select Industries in China and Trade Tensions with the U.S.
Source: Goldman Sachs, Seafarer.2

The second reason why an industry may be more exposed to U.S.-China tensions is that it has become linked to environmental, social, or human rights controversies. For example, the discussion in the U.S. of surveillance technology in China has grown increasingly negative over the past several years, particularly as it relates to how this technology strengthens the Chinese security state and allows it to persecute minority groups. Chinese companies involved in this sector have faced scrutiny from U.S. policymakers, the media, and activists. The level of criticism directed toward this industry continued to build until, eventually, many companies in the industry were placed on the Commerce Department’s Entity List and largely shut out of the U.S. market. The punitive action appears to have been applied with little regard to the companies’ level of involvement in these activities.

Analyzing risk is difficult because the sectors that are most at risk change over time. Predicting which industries will suddenly emerge as the focus of scrutiny is not always possible. Slower-moving controversies can be tracked, however. Investors should monitor the China-related controversies most frequently discussed by U.S. policymakers, journalists, and advocacy groups, to identify whether they are closely linked to specific industries in China and whether policy changes under discussion would have a significant negative impact on Chinese companies operating in that sector.

Evaluate Company-specific Risk Factors

Chinese companies may have characteristics that make them particularly vulnerable to shifts in the U.S.-China relationship. One such risk factor is ownership. State-owned enterprises (SOEs) are often viewed as a proxy for the Chinese government. As a result, the actions of these companies are more likely to come under scrutiny by U.S. policymakers than are actions by completely private companies. At the same time, SOEs have greater access to government assistance and resources, allowing them to better endure difficult conditions than their private sector peers.

Companies linked to social or environmental concerns also have elevated risk. A company that provides equipment and support to a Chinese government policy that has been condemned in the U.S., such as the detention of Muslim citizens in Xinjiang, is more likely to be targeted. The revenues derived from involvement in the policies may not account for a large share of their business, but their involvement is nonetheless sufficient to expose them to punitive actions by the U.S. government.

Chinese companies at the forefront of strategically important technology or an influential communications platform are more likely to face scrutiny. For example, Huawei has been the leader in China’s efforts to export 5G technology to the rest of the world. The prospect of it occupying a critical role in the telecommunications infrastructure of countries around the world has made it a major target for U.S. policymakers. The rise of social media platform TikTok, which is owned by a Chinese company, as a major platform in the U.S., along with persistent allegations that it is censoring activity on its platform, has turned the company into a major target.3

Companies that rely on access to U.S. capital markets or dollar-based financing are more exposed to shifts in the relationship than companies that do not. Chinese companies listed on stock exchanges in the U.S. are vulnerable to the threats of a forced delisting. Were they forced to delist, many of these companies would not be able to list on mainland exchanges, because of their use of the variable interest entity (VIE) structure. Some companies could list on the Hong Kong exchange, but the process of changing is likely to be disruptive for investors. Chinese companies that depend on significant U.S. dollar financing also face heightened risk, as this financing is often routed through the U.S. financial system. Were a company to be sanctioned by the U.S. Treasury, access to dollar-based financing would dry up.

A last category of Chinese companies that are vulnerable are firms that rely on a regulatory exemption from U.S. restrictions. Most of these firms are the Hong Kong-based subsidiaries of Chinese firms. Companies operating in Hong Kong are generally not subject to the same export restrictions the U.S. applies to mainland Chinese firms. The U.S. Congress passed the Hong Kong Human Rights and Democracy Act of 2019 to require annual certification from the State Department that Hong Kong is still sufficiently independent to justify sperate treatment from the mainland. In May of 2020, the Chinese government announced its intention to push through a new national security law for Hong Kong in response to the city’s ongoing protests. As a result, the U.S. government announced that it no longer viewed Hong Kong as sufficiently independent and would begin the process of terminating the city’s special status with respect to U.S. law. Companies relying on these exemptions face a persistent risk that their operating environment will change significantly.

One telling indicator of the risk facing a Chinese company is the extent to which it engages in lobbying in the U.S. Like their U.S. counterparts, Chinese companies facing a higher risk of adverse actions by policymakers tend to spend much more time and resources trying to sway opinion in Washington.4

Determine Whether a China Risk Premium Is Warranted

China risk premiums are based on judgments by investors of how the risks from U.S.-China tensions may affect an investment. Risks include the impact on a company’s profitability, access to critical technology and components, the ability to expand overseas, and volatility in its share price. Also relevant are risks to investors from potential investment restrictions and reputational damage from being linked to a company whose practices are viewed as objectionable.

China risk premiums can vary significantly across investments. An investment in a company that is domestically focused, has few foreign suppliers, and is engaged in business activities viewed as routine is unlikely to have a significant China risk premium. A company that is engaged in practices deemed objectionable, highly reliant on U.S. technology and capital markets, and closely linked to the Chinese government may have a much higher China risk premium.

When the risks are known and their impact can be estimated, investors may decide to raise the hurdle rate for an investment – that is, require a higher rate of return relative to the return on a similar investment in other countries – in order to be compensated for this risk exposure. When the risks are less clear and their impact uncertain, investors may base their judgment on a subjective analysis of the risks facing a company and a range of projected outcomes.

Like other risk factors, a high China risk premium should not necessarily be determinative of whether investment is justified. It is an attempt to incorporate a specific type of risk into the overall assessment of an investment’s merit.

Monitor for Events That May Change the Assessment of Risks

Once the review of risks has occurred and an investment is made, investors should carefully monitor events that could change their initial assessment. An aspect of an investment that was viewed as low risk may become higher risk as events change. For example, a company may be engaged in a line of business that was previously viewed as benign but is now a lightning rod for criticism. Investors that fail to monitor for such developments may not recognize the change until the risks of the investment have already increased significantly. Certain risks may become less salient over time, as a company takes actions that limit its vulnerability to shifts in the relationship. For example, Chinese companies listed in the U.S. can reduce the potential disruption that would occur from a forced delisting by pursuing a secondary listing in Hong Kong. Reducing its reliance on the U.S. can help make a Chinese company less sensitive to changes in the relationship between the two countries.

A significant challenge for investors in this process is to avoid becoming anchored in their initial analysis of an investment. It can be hard to acknowledge that a great company may have mortgaged its future by linking itself too closely to the Chinese state, thereby exposing itself to significant risks. It is important to be intellectually honest and recognize that the China-related risks of an investment will change over time as the U.S.-China relationship evolves.

Establish Guidelines for When to Exit or Increase Exposure

When analysis of events indicates that the risks of an investment have changed significantly, investors face the difficult decision of how to react. To the extent possible, they should try to establish clear guidelines about when a change in risks should prompt a review of a position. This review involves evaluating the current performance of the company, revisiting the original case for the investment, and determining whether the investment still has merits in light of the new risks.

After such a review, investors may determine that an investment is still attractive despite the risks. In these situations, it may make sense to subject an investment to heightened monitoring in order to validate the assessment of risks. In other cases, the accumulation of risks may be so grave that exiting the position immediately is warranted.

There may also be situations in which investors review the issue at hand and determine that the market has exaggerated the severity of risks or overstated the potential impact on a company. In these situations, a well-prepared investor might choose to increase his or her exposure to an investment, in order to benefit from the overreaction of the market. During periods of heightened U.S.-China tension, investors well-versed in the complexities of the relationship may find opportunities amid the turmoil.

The Path Forward

Escalating political and economic tensions between the U.S. and China present challenges to many traditional methods of investment analysis and risk management. They also raise the larger and more fundamental question of whether the political and economic systems of the two countries are compatible over the long run. Few voices are supporting the notion that China and the U.S. can coexist peacefully. Some investors may even question whether investing in China is advisable under any circumstances, given the apparent trajectory of the U.S.-China relationship.

It is important to keep in mind that this relationship has been through many periods of heightened tension that have threatened a breakdown in relations. Each time, both sides recognized that they have much more to gain from cooperation than conflict and ultimately took steps to mend frayed relations.

Although the sources of friction between the two countries seem more numerous than ever before, so are the positive linkages. The flow of people, trade, and investment between China and the U.S. is unprecedented. Since China began its economic reforms, in the late 1970s, millions of businesspeople, investors, workers, and students have benefited from the interaction between the two countries. It will fall upon these people to push for a renewal of the relationship and the establishment of new long-term sources of cooperation. One basis of cooperation can be the sense of shared prosperity that arises when U.S. investors are able to access China’s growing capital markets and benefit from the success of its companies.

In the meantime, investors will have to navigate the dilemma of a market that is too big to ignore but full of new and complicated risks. Faced with these uncertainties, the best approach is to try to understand the risks, make informed decisions based on that understanding, and be vigilant for developments that change the assessment of these risks.

Nicholas Borst,
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
As of March 31, 2020, the Seafarer Funds did not own shares in the entities referenced in this commentary.
  1. Yi Huang, Chen Lin, Sibo Liu, and Heiwai Tang, “Trade Networks and Firm Value: Evidence from the US-China Trade War,” Social Science Research Network (SSRN), 19 December 2019.
  2. Kinger Lau, Si Fu, Timothy Moe, and Jack Wang, “China Musings – Pricing the Likelihood of a Trade Deal: Introducing our Trade Tension Barometer,” Goldman Sachs, 20 June 2019.
  3. Giles Turner and David McLaughlin, “China’s TikTok Needs U.S. Review over Startup Deal, Rubio Says,” Bloomberg, 9 October 2019.
  4. Zhang Qi, “As U.S. Pressure Grows, So Do Chinese Firms’ Lobbying Expenses,” Caixin, 3 December 2019.