- China vs. U.S. on trade is a no-win war neither wants to play.
- In an all-out trade war, the U.S. wins.
- Measures China could take to even its score with the U.S. and what U.S. companies that could get hurt the most if relations sour to the extreme.
China's Plan to World Domination
The Chinese government wants to control its future and that of everybody else at some point in the future. Its leaders are patient enough and smart enough to methodically gain dominance of the global economic order, one industry at a time. Let's review:
China requires that foreign companies desiring to invest in its economy must create joint ventures with Chinese-owned companies and allow access to IP (intellectual property) over the course of the contractual arrangement. At the end of the joint venture, the Chinese company is supposed to relinquish the IP and not use it. But that is not what happens. In practice, the Chinese companies continue to use the IP gained from joint ventures and compete against the foreign companies. The Chinese government looks the other way, thereby indirectly condoning the theft and illegal use of IP worth hundreds of billions in dollar value each year.
Reviewing the China Miracle
The Chinese government also subsidizes Chinese companies in order to allow those companies to offer lower prices, both in China and abroad. The government picks strategic industries to subsidize at the various points in its economic development. First, it was heavy manufacturing, steel, aluminum, construction, and everything else related to infrastructure because China needed to build its own infrastructure of roads, railways, ports, etc. in order to build a foundational base for future economic growth. It brought in the know-how from foreign companies initially, using limited contracts and joint ventures, controlled by Chinese companies for the more technically complex projects until the domestic companies had gained the skill and expertise to build anything. Then, the building began in earnest.
And, of course, all of the huge projects required labor, something of which China has in abundance. But the culture had to be transformed from a rural, agricultural one to an industrialized economy with greater concentration of the population in cities. Fortunately, in China, when the government makes a suggestion, everyone knows that it is best to take the hint, and tens of millions of people uprooted themselves and moved to the cities. It may have been the greatest migration of population in history over such a short time.
Once the infrastructure was in place (to varying degrees by region) and China had carved out a significant share in heavy industry for exporting, it moved to more consumable goods that were easy to produce. Cheap labor, disregard for working conditions or the environment, along with government subsidies enabled China to underprice global competition, one industry after another.
Then, China became even more strategic in its thinking. It went after key natural resources on a global scale until it found itself being turned away by government oversight agencies concerned about allowing foreign ownership of strategic resources. China then focused on rare earth metals.
Not Just Dominating Market But Gaining Outright Control
China also cornered the market in most rare earth elements a few years back by using its position at the time as the swing supplier. It could produce more rare earth elements than it needed domestically so it would flood the global market with excessive supply driving down the price thereby causing the closure of many mines outside of China. Most notably for U.S. investors was the closure of the Mountain Pass mine then owned by Molycorp which spent a lot of money closing down its mining and refining operations.
Then, China decided to restrict the supply of rare earths which resulted in the price rising quickly. Molycorp and other mining companies then spent a lot of money closing, borrowing heavily, to reopen those mines and search for new resources. Billion were spent around the world on mine infrastructure to take advantage of the higher prices. But then, as supply began coming back onto the world markets, China once again flooded the market with cheap supply forcing the prices down and many mines into bankruptcy. Chinese companies then went on a buying spree, picking up many world class rare earth mineral reserves on the cheap. China now accounts for around 95% of world production of rare earth elements.
Rare earth elements are necessary in many electronic devices as well as magnets and military equipment. We can't build missiles, planes or guidance systems without rare earths. We also can't build smart phones. Further rare earth elements are used in alloys to harden and strengthen metals such as steel and aluminum while reducing the overall weight. These are necessary to reduce the weight of cars, trucks and planes in order to improve fuel efficiency. While we're at it, the rare earth metal, cerium, also makes such things and catalytic converters possible to improve emissions from internal combustion engines. Wind turbines require huge magnets which rely on rare earth metals. The list goes on and on.
Next Up Is Cobalt
The problem is that while rare earth metals are in abundant supply on a global scale, those elements rarely occur in concentrations that make mining financially feasible. The Chinese have basically cornered the market and become the only reliable source for resources that are critical to so many products we all take for granted. The latest move by the Chinese companies is an attempt to corner the global market on cobalt. Why is cobalt important? It is necessary for the production of batteries. Everyone is so focused on lithium that they forget that small amounts of cobalt are also necessary to build lithium-ion batteries for smart phones, electronic and hybrid cars, back-up battery systems for facilities, home and the electric grid, as well as many other electronic devices.
The big difference is that there are several sources of lithium buy very limited supplies of cobalt, most of which are located in the Democratic Republic of Congo, much of it mined by hand. China already supplies 85% of the world demand of refined usable cobalt oxides. The other 15% primarily comes from Finland, but the source of the unrefined cobalt is still the Congo.
China has identified another critical resource that it can easily control to take advantage of the coming increase in demand. EV (electronic vehicle) battery demand for cobalt in 2017 was about 26,000 tons. McKinsey, a global consultant, predicts that EV battery demand will increase to 550,000 tons per year by about 2026. The price of cobalt has increased from $26,000 per ton in 2010 to $90,000 per ton today. The increased demand combined with limited supply options means that the price could go stratospheric in coming years. Controlling the supply of such a critical resource could put China in control of several more growth industries. If the EV adoption worldwide goes as projected, China could require all automakers to build their cars in China. That is essentially what it did with many electronic manufacturers using its strangle on rare earth elements.
So, the point to this potential trade war is much more far reaching that the media has explained. If America continues to sit on its hands, as our presidents have done over the past two decades, our military and many of our manufacturing companies will become solely dependent upon China for strategically critical materials. We would not be able to build fuel efficient cars, trucks or buses. Nor would we be able to build planes and defense systems to defend ourselves without permission from China. That doesn't make me feel safe in terms of national defense or world peace.
The new China policy of making the country 80% self reliant by 2025 would require even more free trade violations. China wants to become the world leader in innovation and will do so if unimpeded by the rest of the world through its "Made in China 2025" initiative. Included in that article is a list of the ten industries that China wants to dominate by 2025. I will say, they do dream big in China. And if that dream comes to fruition, it will undermine the rest of the free world and make China the largest economic power on the face of the globe, controlling nearly everything of importance to life as we know it.
As to its continued dependence on gaining access to foreign IP, here is a quote from that article that I believe sums it up pretty well: "Despite advances it has made in hi-tech industries, China still depends on foreign technology transfer to push forward its own innovation agenda and next-generation manufacturing goals. As such, analysts said US tariff measures could hurt the implementation of China's 2025 goals."
In other words, China cannot attain its goals without continuing to double-dealing with the rest of the world on trade and IP matters.
Outcomes of an All-Out Trade War
We can really only speculate on how a trade war would unfold, of course, but my sense (and logical conclusion) is that China would end up worse off than the U.S. in the end were a trade war to escalate.
China does own a lot of U.S. debt. It could flood the bond markets and cause the USD (U.S. dollar) to lose value. But that would also end up artificially lowering interest rates in the U.S., as well. U.S. debt would become cheaper to service and keep our deficits from spiraling higher. A lower valued USD would also make U.S. goods more price competitive on the world market enabling U.S. companies to sell more, also helping our economy.
On the reverse side of this scale, what would China hold in its reserves if not USD? It would need to buy other currencies to add to its reserves. Its currency would rise relative to the USD, as would other currencies it exchanged its reserves into, all of which would make U.S. products cheaper practically everywhere else in the world. With tax reform in place and regulations being rolled back, manufacturing in the U.S. could make a nice comeback.
Inflation in the U.S. would rise as raw materials and finished imported goods would cost more in USD terms. The higher cost of imports could lead to more essential products being made in America. It is cheaper to use a deflated USD to buy raw materials and then do the value added processing here than to import higher cost finished products from afar. Robotics would need to be deployed extensively to make up for the lack of sufficient labor.
The Big Stick: WTO Membership
Yes, there would undoubtedly be pain on our end. But the pain in China could be much worse. If China does not mend its ways, a trade war will come. It was a mistake to admit China to the WTO (World Trade Organization) without preconditions. The biggest stick of all would be to kick China out of the WTO unless it opens up its economy, stops allowing the theft of IP, and plays fair with trading partners.
It loses roughly 90% of complaints lodged against it through the WTO. This would seem for many to be the best means of solving disputes with China. Unfortunately, China may agree to comply with WTO resolutions on paper but then rarely implements that to which it has agreed. When it does other barriers are erected to maintain Chinese domestic companies' dominance. The WTO works well in the interest of global trade with most developed countries in the world but has been ineffectual in dealing with China.
There needs to be a more united front by the rest of the developed world. I believe there need to be conditions that must be met by a specific deadline. The prize for China: to be allowed to continue to be recognized by the members of the WTO. If not, they get booted which would do tremendous damage to China's economy. I really think it is the only leverage the world has to force China to play fair. And I also believe that this is the most likely outcome of an unbridled trade war.
China would face high tariffs for its goods throughout the world. Its exports would fall precipitously and never recover. It would end up becoming a next importing economy, and its reserves would dwindle. Its glorious dream of One Belt, One Road would have to be scrapped. It would become more isolated. All of these things are too important for China to risk.
The alternative is to let China keep bullying its way to economic dominance and in control of all critical materials needed by strategic industries on a global scale. Any nation wanting to defend itself would need China to allow it do so. That is not a world of free trade that the globalist view desires. It is not the path any free and independent nation can afford to allow the world to continue down.
China's Secret Weapon
There is this one huge advantage that China has which is not present in any other major economy in the world. If our government wanted us to boycott a product, it would need a good reason like safety issues to get a majority of its citizens to follow such an edict. However, in China, if the government tells its people to boycott a product, especially a foreign made product, compliance is nearly 100%. Those who don't comply with a government edict could face penalties.
It has been written that Tesla (TSLA) would be the biggest winner if China opened up its auto market to imports; something President Xi recently promised to do. But that would only be the case if the government wanted Tesla to be the big winner and sell more cars in China. If not, it could announce a boycott of Tesla autos. To take it further, local police could pull over Tesla drivers and issue citations based upon the government edict. I am not trying to indicate that I believe this will happen, merely that it could. Government control in China is just that pervasive.
So, the secret weapon is its government's ability to control behavior. A good example is the boycott of the South Korean tourism industry which cost that country an estimated $6.8 billion in 2017. The boycott extended beyond tourism to car making and other industries. Four other modern day boycotts against the U.S., Norway, Japan, and France have taken their toll. But these were far smaller in scale than what we could expect from China if it thinks that it has had to give up too much in negotiations (a fair bet at this point).
Companies That Could See Damage In A Chinese Retaliation
So, which U.S. companies are likely to lose the most in such a scenario? Let's take a look at which U.S. companies generate the highest percentage of revenues from China. You may be surprised to find that some of those companies with the greatest exposure are from the technology sector. This list was the most recent I could find (based upon 2015 reported revenue) and comes from Quartz at qz.com.
Company (Ticker Symbol)
Revenue Exposure to China (%)
Skyworks Solutions (SWKS)
Wynn Resorts (WYNN)
Micron Technologies (MU)
Yum Brands (YUM)
Applied Materials (AMAT)
Texas Instruments (TXN)
Microchip Technology (MCHP)
Lam Research (Lam)
U.S.-based companies experiencing strong revenue growth in China that could also be hurt by product boycotts or tariffs include Nike (NKE), Apple (AAPL), Starbucks (SBUX), Tesla (TSLA) and Tapestry (TPR) which was formerly known as Coach. A few other names proffered by my friends and fellow Seeking Alpha members (Mercy and Mayascribe) are: McDonalds (MCD), Boeing (BA), General Electric (GE), United Technologies (UTX), Caterpillar (CAT), Las Vega Brands (LVS), General Motors (GM), Wayfair (W) and Advanced Micro Devices (AMD). All have significant exposure to China and investors who own these stocks should keep a sharp eye glued to the trade issue.
On the flip side, Chinese companies that may find growth hampered by China being excluded from the WTO include: Alibaba (BABA), Weibo (WB), Ten Cent (OTCPK:TCEHY), BYD (BYD), YY, (YY), and Baidu (BIDU) just to name a few of the more recognizable names. And then, there are other foreign multinationals such as Johnson Controls (JCI) that do a ton of business in China. How will they fare? It is hard to say at this juncture as there is not telling what nations, if any, will support the U.S. position if/when a trade war were to ensue.
Another great article by another author with a slightly different point of view is "Everything You Need To Know About The Possible Coming Trade War," by Dividend Sensei. It is well written and provides more insight to other aspects of a potential trade war. I was already in the process of writing this article when I came across it but decided that there was something more to be said.
If you have any questions, please feel free to ask them in the comment section below and don't forget to hit the "Follow" button next to my name at the top of this article. For those who would like to learn more about my investment philosophy, please consider reading my original series "How I Created My Own Portfolio Over a Lifetime".
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
This article was written by
Founder of Bern Factor LLC, an independent research and publishing firm located in Virginia, and CEO of Friedrich Global Research, an equities research firm covering over 20,000 companies in 36 countries worldwide . My association with the Marketplace subscription service, Friedrich Global Research, is a collaboration with Mycroft Friedrich, another contributor on Seeking Alpha. Together we have nearly 80 years of investing and analysis experience. I am a former CPA (1990 -2017) and became a CFA charter holder in 2000. I consider myself an expert in Quantitative and Qualitative analysis and have extensive experience in Technical Analysis. I also have a deep interest in stock market history and hold degrees in Economics (BS) and Management Information Systems (MBA). I have been actively involved with investment analysis since 1985 but have been a student of investing since the 1960s. I owned my first individual stock position while still in high school. I am a student of Benjamin Graham and Warren Buffett. I have achieved a uniquely diverse experience from multiple careers that has allowed me to develop a broad perspective enabling me to look at the big picture of macroeconomics all the way down to the detail of a retail unit or factory floor. In my youth I was in retail, then served in reconnaissance during my tours in Vietnam. I have been a blue collar, union worker in a factory and a manager in services, hospitality and transportation as well as a manager of professional staffs. I have more than 20 years of experience each in both the public and private sectors. I have personal points of reference that many analysts will never have. I bring more to the table than just the theories and models I have studied or built. To understand more about my investing philosophy please visit my website.
Analyst’s Disclosure: I am/we are long BA, AAPL, UTX, BABA, YY, TXN, YUM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.