Since the U.S.-China trade war began in 2018 with tit-for-tat tariffs, frictions between the two nations have flared in technology and finance. In addition, with the sanctions on Russia and escalating tensions over Taiwan, geopolitical considerations likely will gain more weight in investment decisions.

While this situation poses rising geopolitical risks for investors compared to the past era of globalization, our medium-term baseline still expects mutual economic and financial interests between these two large economies will offset political pressures to act more quickly and dramatically. Instead, we anticipate a gradual trend of manufacturing and supply chain shifts over the next several years, balanced by mutual interests to maintain access to each other’s large domestic markets.

Supply chain diversification: inevitable, but likely gradual

The trade war disrupted trade flows between the U.S. and China in 2018-19, and reverberated along global supply chains. However, the COVID-19 pandemic caused wider damage to the global manufacturing sector, and subsequent stimulus packages across countries actually boosted demand for Chinese exports.

China’s export capacity has since been tested repeatedly, through waves of domestic COVID-19 outbreaks, lockdowns, power outages, and regional geopolitical conflict. Exports have not only remained resilient, but China had also gained trade market share during the pandemic. Despite surging global commodity prices and an elevated domestic Producer Price Index (PPI), China has managed to keep its export prices competitive – in fact, they have risen much less than U.S. import prices from elsewhere.

In addition, it may take years for substitute markets to catch up, considering the complexity and capacity of supply chains, as well as market reforms needed to facilitate manufacturing and exports. Meanwhile, the export sector, being labor-intensive, remains key in supporting domestic employment, and thus China would strive to maintain its stability.

Therefore, while supply chain diversification is inevitable, we believe the process will be gradual given the reliability and affordability of Chinese goods, especially in a high inflation environment.

Chinese consumer strength makes supply chains stickier

Many U.S. companies have established factories in China over the decades, and their supply chains are tightly linked to China. We believe many such factories will remain in China to continue meeting local demand – as evidenced by robust foreign direct investment (FDI) in China since the trade war. The country ranks among the biggest markets in the world for many products, boasting a middle-income group of more than 400 million people. Here are two examples:

• Semiconductors
  Global semiconductor sales reached $556 billion in 2021, and U.S. semiconductor companies accounted for sales totalling $258 billion, or 46% of the global market, according to the Semiconductor Industry Association (SIA). However, only 12% of modern semiconductor manufacturing capacity is located in the U.S.
  
  China is the world’s largest consumer of semiconductors ahead of the U.S., because of the size of its domestic electronics market and its status as a production base for entire industries. In 2020, China imported $378 billion in semiconductors and assembled 35% of the world’s electronic devices, according to SIA.
  
  Meanwhile, data from market research firm TrendForce show that Taiwanese foundries (factories contracted to make chips designed in other countries) accounted for 64% of the global market in 2021, with the Taiwan Semiconductor Manufacturing Company (TSMC) alone having 53% market share. In addition, Taiwan produces roughly 90% of the most advanced semiconductors, used in automobiles, smartphones, military technology and much more, according to a 2021 report from Boston Consulting and SIA.
  
  Given the complexity and interdependence of countries in the global semiconductor value chain, any potential semiconductor supply chain disruption could have global ramifications. Although the U.S. recently adopted new legislation, such as the Chip Act, in an attempt to counter and compete with China’s technological development, revenue exposure to China within the technology sector remains high, and we think any shift in supply chain is likely to be secular rather than cyclical, given all of the hurdles.
• Automotive
  Most U.S. auto companies in China are joint ventures with Chinese firms and cars are built for local consumption, so the direct impact from tariffs should be small.
  
  In terms of secondary impact, China remains critical to the global market, as the largest auto market in the world in terms of both demand and supply. In 2021, China produced 26 million units, making up 33% of the global total, and sold 26 million units, representing 32% of global sales, according to data from the International Organization of Motor Vehicle Manufacturers.

Reverberations may be felt across global financial markets

For several decades up until early 2021, U.S.-Chinese financial links had been getting tighter – as evidenced by a wave of Wall Street IPOs by Chinese companies, the pumping of money into Chinese start-ups by U.S. venture capitalists, and the flow of U.S. institutional investment capital into China’s public markets for stocks, bonds, and derivatives.

But international finance has become a key part of geopolitical dynamics, and U.S.-China tensions have created a rift between the two rivals’ financial systems that could raise the risk of global financial market volatility.

In the past few quarters, global investors have been rattled by the delisting of DiDi Global from the New York Stock Exchange, and sanctions on Chinese military-linked companies, which caused forced divestment by U.S. investors.

Chinese companies are finding it harder to raise capital in the U.S., as U.S. regulators seek to restrict listings of Chinese companies on U.S. exchanges over auditing compliance issues, and China’s regulators scrutinize the Variable Interest Entity (VIE) structure of Chinese companies seeking to list abroad.

Cross-border asset holdings, however, are now high – a fact that both governments likely will take into consideration to avoid collateral damage. At the end of 2020, U.S. holdings of Chinese securities neared $1.2 trillion, while Chinese holdings of U.S. securities reached as much as $2.1 trillion, according to the data from the U.S.-China Investment Project.

According to the UNCTAD World Investment Report 2022, FDI stock in China reached $2.1 trillion in 2021, with $181 billion of global inflows. On the China side, as of June 2022, it is the second-largest holder of U.S. Treasuries behind Japan with $967.8 billion, according to statistics from the U.S. Department of the Treasury, and China holds $3.1 trillion in forex reserves as of June 2022, according to China’s State Administration of Foreign Exchange.

China remains tightly linked with Western financial infrastructure

Though China has been building and promoting its own yuan-based Cross-Border Interbank Payments System (CIPS) since 2015, it continues to use the international SWIFT messaging system as the secure communication channel between participating financial institutions, both across borders and to its own foreign bank branches and subsidiaries.

Further, in spite of China’s long-term strategy to internationalize the yuan, it faces an uphill battle in shaking up the global currency hierarchy, which will likely be dominated by the U.S. dollar for the foreseeable future.

The yuan had only a 3% share in global foreign reserves as of end-2021, in contrast to its 11% share in the IMF’s Special Drawing Rights (SDR) basket of international reserve assets, according to IMF data. The use of yuan in trade and financial transactions is subject to market expectations for the exchange rate, confidence in onshore assets, and now increasingly geopolitical considerations.

China’s recent regulatory storm, recurring COVID-19 outbreaks, and deteriorating geopolitical environment have taken a toll on the economy and eroded investors’ confidence. In addition, the reforms to foreign ownership limits, full liberalization of capital mobility restrictions, and alignment of international accessibility standards will also take time.

What’s next for China’s integration into global financial markets?

Bond issuance in the USD market by Chinese state-owned enterprises (SOEs) has shown signs of deceleration. For the major part of the last decade, Chinese companies accounted for the majority of the annual issuance in Asian dollar bond markets. We expect the trend to slow given reduced outbound investment from Chinese SOEs due to opposition to Chinese owning critical assets in developed markets.

Further, we could see divestment of offshore assets, especially in developed markets, on geopolitical concerns. Issuance from Chinese technology companies is also likely to drop due to regulatory pressure from both onshore and U.S. regulators, which would curb their M&A appetite. Hence, we expect most USD issuance from Chinese companies to be for re-financing only.

Other than geopolitical considerations, China’s barriers to foreign investors still exist. These include, but are not limited to: high leverage, inadequate information disclosure, lack of a rule-based default resolution framework, different auditing and ratings practices, a partially-open capital market, and the still-transitioning monetary policy system and financial regulations.

Overall, the heavyweight Chinese economy and its strong ties to the global market make any large-scale sanctions a double-edged sword. We believe that both China and the U.S. will carefully calibrate the risks and avoid a large-scale confrontation in the next few years, at least before any decoupling is reasonably advanced.

Implications for investors

Looking forward, we expect the rivalry between China and the U.S. to continue, but we believe this will be a gradual process. The stickiness of the supply chains, the large Chinese consumer market, and the intertwined financial systems make an abrupt decoupling an expensive proposition. The process is unlikely to be a linear one and we expect headlines and volatility, which can create large valuation gaps as prices diverge from fundamentals.

In such an environment, we see opportunities in select high quality Chinese credits with robust balance sheets and resilient business models to withstand the macro volatilities. An example would be the auto sector, especially new energy vehicles, where the companies cater largely to domestic demand and would be less impacted by tariffs. Green industry and selected (non-sensitive) tech players also present opportunities given the secular trends of decarbonisation and digitalization.

For more insights on the fragmenting world and other key trends affecting the global economy and markets, please read our 2022 Secular Outlook, “Reaching for Resilience”.