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US-China – Are We Heading For An All-Out Trade War?

By Devan Kaloo, Global Head of Equities, Aberdeen Standard Investments

The US-China trade war has escalated dramatically. Just a few weeks ago, we were predicting a fairly quick resolution, possibly in June. Recent events have changed our thinking. We still believe both sides can strike a deal – but the path to that accord now looks far more protracted and challenging. There’s also a danger the situation could escalate further. The questions are: what does all this mean for our investors? And how are we positioning our portfolios in response?

Tensions escalate

It was all starting to look so positive. Ahead of the G20 summit in November, US President Trump said he had “good vibes” about the negotiations. Beijing was also making positive noises. Following further high-level talks, hopes of a deal in May mounted. But then Trump’s negotiating team said that China was backtracking on its promises. Trump took to Twitter, threatening to hike tariffs from 10% to 25% on $200 billion of Chinese goods. These are now in effect. The president also said the US would target the remaining $325 billion of Chinese imports that are currently untaxed. China quickly retaliated, ramping up its own tariffs on $60 billion of US imports.

Recently, Trump signed an executive order that effectively bans US firms from using telecoms equipment made by China’s Huawei and ZTE. He claimed the ban was on the grounds of national security. Huawei is nominally employee-owned, although questions hang over how much influence the government exerts over the firm. US companies will now have to obtain a licence to supply Huawei with the high-spec products it needs to make its microchips. China has responded, saying it will cancel all US soy purchases. This is a major market for the US: in 2017, according to Forbes, 57% of all US soybean exports went to China. Beijing also threatened to halt the export of rare earths to the US. These minerals are vital for high-tech consumer electronics, such as iPhones. The tit-for-tat trade war continues.

Huawei fallout

Huawei plays a key role in the global technology supply chain. Its latest result confirmed sales of US$105 billion last year. The report also showed the company used up to 5.3%, or US$25 billion, of global semiconductor sales. Disruption to the tech sector would therefore be significant should Huawei struggle to sell its smartphones outside China for a sustained period.

The longer this drags on, the more nervous investors and companies will become. We could see some pullback in capex spending in the technology sector. This would lead to a flatter-than-expected recovery in demand for semiconductors in the second half of 2019. Huawei is also a significant player in 5G globally. Its blacklisting may delay the rollout of the network. However, as Huawei’s market share falls, rival firms, given enough time, could fill the gap.

What does this mean for our strategy?

The recent upheaval has affected our global emerging markets portfolio. Stocks of note are Samsung Electronics and Taiwan Semiconductor Manufacturing Co (TSMC), which we have held for 17 and 14 years respectively. Both their share prices fell in response to Trump’s announcement, illustrating the complexity and interconnectedness of the tech sector. This also demonstrates how sweeping changes can disrupt business. Nonetheless, both firms have solid economic moats and increasing barriers to entry. They are also positioned to benefit from the structural growth of computing power. This includes AI, data centres, autonomous driving, high-powered computing and 5G.

That is not to diminish the current challenges the companies face. Samsung was expected to increase market share in the wake of 5G. This could now be disrupted. Demand for memory chips will also slow in the second half of 2019. This is because Huawei stockpiled chips in the first half in expectation of the ban, artificially inflating demand. But there are positives. Samsung is a competitor to Huawei in the handset space. It should grow sales as a result of the latter’s ban. This is particularly true in Europe, where Huawei had caught up on Samsung in recent years. Meanwhile, Huawei is only a small memory and display customer – demand that can be absorbed by other vendors.

Longer term, sales of Samsung’s dynamic random-access memory (DRAM) semiconductors should continue to drive returns. This is a consolidated market, with high barriers to entry. According to analysis by Bernstein, the top-three players make up 97% of global market share. Of which, Samsung is number one with close to 50% of industry operating profit. As computing becomes more complex, demand for DRAM will increase. Pricing power is also improving.

For TSMC, the biggest medium-term threat is that a regulatory crackdown prevents it from supplying Huawei. Trade-war-related restrictions on iPhones in China could further hurt the group. However, this is counterbalanced by potential domestic gains for Huawei as nationalistic sentiment among Chinese consumers rises. TSMC also remains the leader in sophisticated wafers and has a track record of pushing the boundaries of technology. Indeed, the long-term dynamics are supportive for more advanced wafers. So, as the sector repositions over the medium term, we expect TSMC’s technological leadership, competitive advantage and scale to give it an advantage in the long run.

Deal or no deal?

There is no doubt that US-China action and rhetoric have hardened. At present, both parties seem to have different viewpoints of what is “fair”. Trump believes tariffs are working. Indeed, he recently threatened to impose tariffs on Mexican goods in a dispute over border security. A trade war was averted after Mexico made concessions. This could further embolden Trump in his fight with China. It also shows he is willing to use trade to punish allies as well as adversaries. The European Union beware.

As it stands, more will become clear after the G20 summit at the end of June. Trump has already threatened a new round of tariffs if President Xi Jinping refuses to meet him to discuss trade. Investors have buckled up for further bouts of volatility. Many have bought risk protection in preparation for any fallout.

Despite all this, we still think a deal remains the most likely outcome. Both sides have too much to lose. China’s economy is feeling the strain. The US recently launched a $16 billion bailout to help its embattled farmers. What could break the deadlock? Heightened market stress incentivised negotiators to seek common ground last time tempers flared. Similar upheaval could once again spur them to seek a deal.

Final thoughts…

The recent sell-off could present buying opportunities but, given the uncertain backdrop, caution is warranted. We continue to focus on strong company-specific stories, with robust business models, good management and healthy balance sheets. We believe this approach will help the portfolio weather what could be a turbulent few months.

Disclosures:

The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

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