Hindsight bias makes surprises vanish. - Daniel Kahneman
Thanks to the constant uncertainty of a never-ending trade war, China has been a difficult region to invest in. Just six months after the trade war unofficially kicked off at the beginning of 2018, Chinese equities were down more than 20% as the list of products getting hit with U.S. import tariffs kept growing. Investors who felt that the two sides would reach an agreement at some point in the near future took long positions in China anticipating a 20-30% rebound once trade relations returned to normal. Instead, the trade war shows little signs of coming to a conclusion anytime soon, and Chinese equities remain 25-30% below their early 2018 highs.
Today, the list of concerns with China is growing. The trade war, which to this point has mostly been limited to levying tariffs on imports, has expanded to Washington considering outright bans on doing business with China. After a period of goodwill gestures by both the U.S. and China earlier this month, it appears that both sides are ready to dig in once again.
For investors considering investing in China, I think there are three main risks to consider. In my opinion, each of them comes with varying degrees of concern, but there's little doubt that all of them are putting significant pressure on Chinese equities. For astute investors, I think this presents a compelling "buy the dip" opportunity.
Let's start by running them down one by one.
Concern Level: Moderate
While there's no direct way of investing in Huawei (it's a privately-held company), there's no doubt that the U.S. drawing a line in the sand with what was at one time the second largest smartphone manufacturer in the world will have consequences felt throughout the Chinese economy. The ban on U.S. companies doing business with Huawei has been postponed twice in order to allow companies to modify their supply chains, but November 19th is looking like the date that the ban will finally be enforced.
On the flip side, Huawei seems to have found alternate suppliers in order to keep production uninterrupted, but it's unlikely it will be the same company it was without being able to do business with the United States. This arguably affects U.S. suppliers like Qorvo (QRVO) and Skyworks (SWKS) more than Huawei, but cutting off one of the largest economies in the world will come with consequences. The push to cut off all business ties with China, regardless of how enforceable or realistic it might be, will be a significant headwind for Chinese equities until we approach a resolution to the trade war.
Ban on Investment in China
Concern Level: Low
I wanted to put that my concern level was none, but since there technically is a possibility it could emerge in some form, I won't rule it out altogether.
This is a political ploy more than anything. It was never realistic that this had a legitimate chance of happening, so I'm not sure why names like Alibaba (BABA) and Baidu (BIDU) dropped sharply on the news still baffles me. Even Mitch McConnell, one of President Trump's staunchest allies, came out and dismissed the idea. This is nothing more than an attempt to gain some degree of leverage in the trade war, and I don't see any way that this gets implemented. Consider it a non-issue.
Concern Level: Short-Term Moderate, Long-Term Low
Trump is playing hardball with China right now, but remember that he wants to be re-elected a year from now. With the potential damage from an impeachment inquiry growing, Trump will likely be under tremendous pressure to claim victories wherever they can be found, and there is none bigger than striking a deal to end the trade war. Thanks to his tweets, we know that he places tremendous value in where the stock market is at to gauge his economic success. A resolution to the trade war will undoubtedly send stocks skyrocketing and that could give him the big boost he wants heading into next November.
In the near-term, equities will remain under pressure as exports shrink, costs rise and manufacturing struggles. In the long-term, I expect this to be resolved to some degree before the election. That should give stocks a boost and raise the possibility that this economic expansion could be extended further.
Sentiment in Chinese stocks is unusually low at the moment, thanks to a number of mitigating factors, but I believe this presents a buy-low opportunity for contrarian investors. Many of the risks appear to be short-term in nature and the long-term potential that would come with a trade resolution is high. This is still an interesting entry point if you're willing to ride it out over the next few quarters.
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