The views expressed are those of the authors and are subject to change. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. For professional or institutional investors only.
What’s changed between the two superpowers?
Mucha: A series of Chinese actions in recent years has made clear to US policymakers that China is intent on challenging US dominance not only in the Asia Pacific region, but globally. For the first time since the end of the Cold War, the US has a peer power that’s capable of doing so.
Under President Xi Jinping, China has greatly increased its espionage in the US and beyond, ramped up economic pressure on countries globally, and used military and political intimidation as a foreign policy tool. It has also implemented sophisticated propaganda strategies and, critically, surveillance and population control technologies that it is now exporting to other authoritarian governments.
The ideological threat this poses to US values, norms, alliances, and US-backed global institutions is one of the few areas of bipartisan agreement in today’s otherwise deeply fragmented Washington.
Is this a temporary effect of President Donald Trump’s foreign policy?
Mucha: No. Democratic presidential candidate Joe Biden is promising to make democracy, human rights, and other core US political values a central part of his foreign policy and to push back on authoritarian regimes. So China could become an even larger friction point in US external relations.
Millán: That said, I believe the risk of outright war would likely moderate in a Biden administration, which I anticipate would take a more professional and therefore more predictable approach to US-China relations, with greater use of diplomacy, more coordination with allies, and a return to rules-based frameworks, including the World Trade Organization and the Trans-Pacific Partnership.
So there is a chance of war?
Mucha: While the risk is higher today than it’s been since the US and China established diplomatic relations in 1979, a deliberate war between the world’s two biggest militaries is not the preferred policy response from either side. To me, the far more plausible risk is an accidental conflict that spirals out of control, particularly in the South China Sea, East China Sea, Taiwan Strait, or North Korea.
What is the strategic value to China of Taiwan?
Mucha: I believe the markets have underestimated the critical importance of semiconductors to China’s economic and military future, and the domestic political capital President Xi has placed in eventually bringing Taiwan — the world’s biggest semiconductor equipment maker — into the government’s One China political framework.
If push comes to shove with semiconductors — remember the US oil embargo of Japan in 1940 that precipitated Pearl Harbor — President Xi may decide that invading Taiwan is worth the considerable risk. However, I believe China is likely to play the long game on Taiwan and continue to build its own domestic capacities.
Wasn’t the recent trade deal a sign of peace?
Millán: The phase-one trade deal between the two countries helped reduce short-term uncertainties but represented only a partial truce. Since the COVID-19 outbreak, the tension has only grown, for a variety of reasons: closer structural relations between Washington and Taipei (including increased US military sales to Taiwan), more assertive military action in the Taiwan Strait by China, Taiwan, and the US, and recent Chinese policy actions in Hong Kong, which raise the stakes for Taiwan’s democratic future.
What is behind China’s new assertiveness?
Mucha: President Xi has developed into a bold leader, who is not afraid to take risks as China continues to exert greater economic and geopolitical influence around the world. This is driving China’s more assertive policy actions in the South China Sea, the expansion of its Belt and Road project, Uighur policy in Xinjiang, and the recent crackdown on Hong Kong.
What might China tensions mean for local risk assets in the medium term?
Millán: Chinese equities are relatively attractive in my view, even with conservative assumptions of a continued downward growth trajectory. The main pillars of this view are reasonable trend valuations; the likelihood that the discount rate will remain stable or decrease; the rising share of the economy that is becoming investable; industry consolidation and institutional developments that are creating new competitive moats for companies; and a continued trend of regulatory reform, which should create more efficient markets.
I wouldn’t be surprised if over the next five to seven years, overall earnings grew by one or two percentage points more than top-line GDP, which in nominal terms should grow by at least 7%. That’s due to the consolidation and institutional reform mentioned above. Putting this together with a stable to declining discount rate over the medium term, I see the most likely outcome as annualized equity returns in the very high single digits.
For credit returns over the same period, it is important to make an assumption about Chinese currency and financial stability. In this regard, the performance of the yuan through the COVID-19 episode and the trade war is instructive, as it shows China’s balance of payments position is solid enough to withstand substantial shocks.
For example, while the balance sheets of other major central banks have expanded aggressively over the last few years, the People’s Bank of China’s has hardly grown, underpinning the currency’s value. China’s positive interest rates represent an important carry opportunity that can drive a path of convergence to the lower rates of the developed world over the medium term and support credit as well.
The main consideration is the potential for instability — whether due to domestic financial risks or to the potential intensification of the US-China conflict — to involve the financial system. Investors with a medium-term perspective need to forecast what the relations between their country and China will be in five or 10 years.
For investors in China from the US, the UK, Australia, and India, the potential for a new cold war presents a significant risk of a complete financial decoupling over that period.
Mucha: Clearly, investing in China will become a more complicated affair in coming months and years if we stay on this national security path.
But as long as we avoid a shooting war, great-power competition is likely to be a long-term market positive as it fosters a more supportive fiscal and monetary backdrop and creates plenty of investable national champions in the US, China, and globally. I believe the markets will gradually adapt to this new geopolitical reality.
This geopolitical competition is likely to be highly disruptive and therefore favors actively managed strategies that marry bottom-up expertise on countries, industries, companies, and various asset classes with the correct reading of these structural changes in the geopolitical and policy backdrops.
It could pay to find long-term thematic exposure to the right trends on both sides of this divide. In China, these include the continuing consumer transformation story, the digitization of services, and climate adaptation. In the US, they include changes in defense spending and national security strategies, tailwinds for dual-use technologies central to this trend, and shifting trade and diplomatic alliances.