The “trade war” isn’t about trade and it’s creating opportunitiesMarketGrader Corp, Index provider16 August 2019
US President Donald Trump once again made global news in early August, with the announcement that 10% tariffs would be imposed by the US on an additional US$300 billion of Chinese goods from 1 September. The announcement was less than 48 hours after his negotiating team concluded its latest round of “trade talks” in Shanghai. While most investors feigned surprise at the US president’s announcement, the truth is that very few expected much progress from the latest round of talks even before Mr Trump’s latest tariff tweet.
MarketGrader1never really bought into the notion that the trade war is actually about trade. The US administration’s goal is not about getting China to buy more of the country’s agricultural output - though this wouldn’t hurt - or is it about limiting abusive Chinese dumping practices when exporting washing machines or solar panels to the US, though these have, indeed, violated World Trade Organisation rules that the Chinese claim to uphold.
The trade war is about curbing China’s most mercantilist and protectionist practices that have kept large tracts of its markets closed to foreign companies. Tariffs, not the subtlest of economic levers, still have a decent chance to effect change. The evidence, though, suggests in the short term this will be difficult.
While the US-China negotiations were important, the more interesting news on the China-US trade war front did not originate from Mr. Trump or his negotiators but, instead, from China’s Communist Party’s Politburo. The country’s governing body concluded an economic review meeting to discuss the country’s second quarter performance and the tone of its post-meeting communique says more about the direction we’re headed than anything coming out of Shanghai after the most recent negotiation round. The Politburo’s message made it clear that China is in this for the long haul. After the meeting, the country’s leadership declared that “we must be good at turning crisis into an opportunity by getting our domestic things done.” In discussing possible government responses to the effect the trade war is having on the economy, China’s leading government body stated that “fiscal policy should be strengthened to improve efficiency and continue to implement the policy of tax and fee cuts.” And further, with regards to potential stimulus of the housing sector, “we should adhere to the principle that housing is used for living, not for speculation … and [the government] will not use real estate as a short-term means of stimulating the economy.”2
The most recent language out of the country’s top governing body confirms some of MarketGrader’s own polling among domestic Chinese investors during the team’s recent visit to the country. The broad consensus among investors we met was that the government is preparing the country for a protracted “trade fight”. The overriding message coming from China’s leaders and prevalent in state-controlled media is one of short-term sacrifice and unity to overcome US bullying. There appears to be renewed interest on the part of the government to stimulate domestic consumption through “supply-side” reforms such as tax cuts and deregulation, rather than fiscal stimulus through massive infrastructure spending or new “stimulus” programs. Furthermore, despite a slowdown in some parts of the country’s economy, particularly manufacturing, the government isn’t loosening its purse strings to stimulate the state owned enterprise (SOE) sector but is instead pushing ahead with reform. Combined with recent limited measures by the People’s Bank of China to ease banking reserve requirements, instead of flooding the system with credit, the country’s leadership has no immediate plans to derail its clamp down on the shadow banking sector or to put a stop to ongoing financial reform.
China does not expect a rapid resolution to the trade war. Instead, it is counting on further stimulus to its domestic, consumer-led economy to help it weather the storm. This conclusion will have significant and positive repercussions for investors in China’s “new economy”.
Domestic consumption – staples and discretionary sector
It is no surprise China’s leaders are talking up domestic consumption, as this has been the country’s economic driver for several years. Although China accounts for only 10% of global household consumption, it accounted for 31% of global household consumption growth from 2010 to 2017, according to a recent McKinsey Global Institute report3. Chinese consumers are not, of course, immune to an economic slowdown any more than consumers in any other economy. However, China’s growing middle class is poised to become so large that any trend tied to the economic cycle—or the trade war—is likely to get lost in a much larger secular, long-term trend. By 2030, according to McKinsey, 58% of Chinese households will belong in the “mass affluent” or higher category, which is higher than the 55% share for the mass affluent or higher category in South Korea today. Chinese consumer patterns are already, by several metrics, approaching those of Japan, South Korea and the United States. As recently as 2017, Chinese consumers accounted for over 40% of global electric vehicle sales, 45% of seafood, 37% of fresh meat and 24% of wine. Chinese moviegoers accounted for 90% of the world’s box office growth between 2007 and 2017. In 2018, Chinese tourists took 150 million trips, a 14-fold increase since 2000; and in 2017, half of trips taken by Chinese travelers were to the Greater China area, which means that a significant amount of travel expenditures are happening domestically to the benefit of domestic firms. Perhaps most importantly, Chinese incomes have been growing, on average, by 11% per year since 20104.
China, however, is not immune to a deceleration in its economy as a result of its ongoing trade conflict with the US. Since 2018, manufacturing activity, industrial profits, vehicle sales and exports have all trended downward. China’s purchasing managers’ index (PMI) showed that manufacturing activity continued to contract in July, albeit at a slower level than May and June. And according to the government, industrial profits fell 3.1% in July from a year earlier. But the government is actively managing these with its measured response focusing on supporting consumers with targeted incentives to purchase automobiles and household appliances, implementing tax cuts, approving smaller infrastructure projects and targeted support for its agricultural sector. The latter focuses on helping farmers increase productivity through the use of technology, which, the thinking goes, should lead to a rise in incomes and thus additional purchasing power for consumers in China’s still vast countryside. While government support for China’s consumers cannot completely counteract the impact tariffs are having, domestic consumption appears to have stabilised from earlier in the year, with discretionary sales rising a stronger than expected 9.8% in June from the prior year period5.
Of the four sectors MarketGrader labels “new economy” in China, technology could be the most adversely affected by the trade war especially if the new round of tariffs does go into effect on 1 September, as it will impact some of China’s largest exports including smartphones, computers, tablets and overall consumer electronics. Furthermore, additional restrictions by the US administration on the export of semiconductors and other components on which China is reliant for its technology manufacturing will dent the country’s technology industry. Consider, for example, that even though China is estimated to produce over 90% of the world’s smartphones, 65% of PCs and 67% of smart TVs, it needs to import the vast majority of the chips that go into them. In fact, the overall value of chips imported into China has surpassed the total value of oil imports, reaching US$312 billion in 20186.
We do, however, see a silver lining in this predicament facing China’s technology sector. State investments in the high value-added tail of the technology supply chain are accelerating. A good example is the ‘China Integrated Industry Investment Fund’, backed by the state and operated by the Ministry of Industry and Information Technology and the Ministry of Finance. The fund recently announced the completion of its second capital raising round, towards its goal of CNY 200 billion (U$29 billion). The fund, which focuses on industries where China is reliant on imports such as chips and advanced manufacturing components, has already made investments in more than nine listed firms, as reported by the South China Morning Post. Overall, China’s domestic spending on research and development grew from US$9 billion in 2000 to $293 billion last year, now the second highest total R&D spending in the world behind only the United States3. The trade war could make China’s technology sector stronger.
Many of the consumer patterns discussed above continue to have a very positive effect on health care expenditures in China, as the country’s middle class demands health services on par with those in developed economies. Chinese households now devote 7% of total discretionary spending to health care, higher than the 5% spent by Japanese households and on par with those in South Korea. US households, by contrast, devote 9% of discretionary spending to health care goods and services3. And while household consumer patterns on health care will certainly propel additional growth, the biggest expenditures in the space will continue to be driven by the government. Ongoing reform has focused on addressing issues such as streamlining the approval of pharmaceuticals to market from their development and clinical trial phases, by drastically increasing the number of drug reviewers across the country. Greater investments by the state in training, recruiting and licensing doctors will continue to be a driver of health care investment, as China has approximately 19 doctors and 25 nurses for every 10,000 people, compared to 27 doctors and 129 nurses in the United States7. According to a recent report published by Health Affairs, health expenditures in China are projected to grow 8.4% annually through 2035. Furthermore, in addition to direct health care expenditures, Chinese consumers are increasingly more concerned about their overall health and fitness, which we believe is leading to increasing expenditures in health and lifestyle products and services. Many of these expenditures are showing up in consumer discretionary spending.
While there is still an opportunity for the US and China to reach a negotiated détente to the trade war, rather than the comprehensive trade agreement President Trump still says is possible, it is evident that China’s leaders are primarily focused on strengthening their country’s consumers to withstand further US tariffs.
While it’s a situation we would rather see avoided, we do believe this will benefit domestic firms across “new economy” sectors as local players continue to gain market share on foreign firms. In summary, while China’s economy will not escape unscathed from this trade war, for investors allocating to China, the “new economy” is, more than ever, the place to be.
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1Index provider for the VanEck Vectors China New Economy ETF
2China can turn US trade war ‘crisis into an opportunity’, says top leadership. South China Morning Post, July 30, 2019.
3China and the world. Inside the dynamics of a changing relationship. McKinsey Global Institute, July 2019.
4China National Bureau of Statistics.
5China’s Consumers Have Driven Economic Growth. Here’s What to Watch to See If It Can Continue. Barron’s, July 24, 2019.
6China completes second round of US$29 billion Big Fund aimed at investing in domestic chip industry. South China Morning Post, July 26, 2019
7National Health and Family Planning Commission.