How To Invest For A U.S.-China Trade War

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by: Sean Li

Summary

A tit-for-tat U.S.-China trade war grows increasingly likely - but investors should make hedged bets in case that it does not happen.

The U.S. overestimates the damage China has done to the U.S. economy and underestimates China's options for retaliation.

Global value investors should get prepared to take advantage of short-term market irrationality to evaluate long positions in Chinese technology companies.

On June 15th, U.S. President Donald Trump announced tariffs on $50 billion of Chinese exports. The Chinese government immediately followed with a proportional $34 billion tariff on U.S. exports. Subsequently, Trump threatened to levy as much as $200 billion more in tariffs in case of Chinese retaliation. Escalating tensions have sent global indices downwards this week.

Trump's trade moves can be broadly interpreted as vindictive of perceived historic intellectual property theft China has engaged in through its state-owned enterprises. China's alleged "unfair trade practices" added fuel to the fire and contributed to form Trump's motivation.

In other words, Trump's recent moves are not addressing anything new - they are political moves and a showing of power ahead of the U.S. mid-term elections in November 2018 where all seats in the House and 35 out of 100 seats in the Senate will be contested.

Taking a big-picture perspective, U.S. exported $169.8 billion of goods to China while importing $478.8 billion in 2016, constituting a trade deficit of $385 billion (Office of the United States Trade Representative).

Two key takeaways from this information:

  1. China cannot sustain in a tit-for-tat trade war against the U.S. due to simple mathematics: the U.S. tariff pool ($478.8 billion) is almost 3x larger than the Chinese tariff pool ($169.8 billion).
  2. The trade deficit of $385 billion seems preposterously high, but is in fact based on misguided logic.

Let's take Apple (AAPL) as an example.

For the purpose of this thought exercise, let's say each iPhone has a price of $500. When China finishes the iPhone manufacturing process and "exports" it to the U.S., $500 is added to the "imports from China" column. In reality, is China really exporting $500 worth of value? In fact, most of that value is generated domestically by Apple, a U.S. company, the value-add of China, or real exports, is likely only ~$15-20.

If the U.S. engages in foolish blind taxation as the Trump's $200 billion blanket tariff threatens, the value being taxed and those being hurt are the American tech companies, not China. On the contrary, a strategy targeting the textile industries, where China actually exports a lot of value, will actually hurt.

With this in mind, the trade deficit is actually less than half of what the U.S. states officially. When taking Chinese investment into the U.S. into account, that amount is even less.

If the U.S. continues to engage recklessly in a trade confrontation with China, introducing additional tariffs on U.S. goods is just one of many ways China can make the U.S. feel pain. The Chinese can start by rejecting the Qualcomm (QCOM) and NXP (NXPI) $44 billion merger. Following that, the Chinese government can make life tough on U.S. companies operating in China and implement restrictions on Chinese investment into the U.S.

The end result of this trade conflict will bloody both superpower economies, and this mutual suffering is the reason I believe the likelihood of both countries going into an escalating trade war to be only 50% or lower and an alternate solution will be negotiated prior to implementation.

The biggest misconception in the markets right now is that a trade war is inevitable because the U.S. is too powerful; looking around the globe, many markets have already began pricing in the potential trade war. On Monday alone, the Chinese indices lost as much as 5% in Shanghai and Hong Kong. In the short term, this presents a good opportunity for smart investors to go long on these battered indices. The downside risk has already been priced in and can further be controlled with hedging strategies. The upside is the markets going back to business as usual if a deal gets done. With leverage, there is money to be made betting on the Chinese indices.

More specifically, companies such as ZTE (000063), which has suffered tremendously from a dual-whammy of Senate decision to ban it from using American chips and investor irrationality, has lost nearly 1/3rd of its value on the Shanghai Stock Exchange and more than 60% on the Hong Kong Exchange. In my opinion, stocks like ZTE are worth evaluating for a short-term long play because its decline is based on an uncertain premise - that a trade deal cannot be reached. ZTE is a state-owned enterprise and the Chinese government would almost certainly include it as part of any deal it does with the U.S. Thus far, however, investors have mostly considered ZTE's issues and the broader trade conflict separately.

One thing foreign investors fail to grasp in China is that the markets are controlled by swaths of retail investors, while in the developed world, the markets are controlled by institutional investors. The biggest difference this makes is there is an extremely pronounced herd mentality and the information lag is significant. Consider this: on Tuesday, ZTE rose by 10% on the Hong Kong exchange, but declined by 10% on the Shanghai Exchange. This is shocking, considering the underlying business is the same. But it makes more sense when you consider Hong Kong being a more liquid and transparent market with far more institutional investors than the Shanghai Exchange - what likely happened is these buyers started picking up ZTE shares for cheap in Hong Kong, while in Shanghai, the markets are still ruled by fear.

Overall, opportunities are abound in the Chinese markets where irrationality and groupthink has prevailed in the short-run. As always, capital chases value and value is always hidden in places most people aren't looking.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.