The Thucydides Trap is a term coined by American political scientist Graham Allison to describe the friction that may arise when a rising power threatens the international hegemony of an existing power. Today, people often use the Thucydides Trap to compare the relations between China and the U.S.:

Summary:

• Despite a decline in FDI flows between China and the U.S., the two countries still have deep economic ties, and even moderate decoupling would have significant impacts in the short term.
• China’s macroeconomic environment and business cycle are different from those of Europe and the U.S., and China’s offshore stock market reflects more geopolitical influences, requiring higher risk-return expectations from investors.

Dynamic Changes in Sino-US Relations

At the beginning of the Trump administration, the decision to impose tariffs on imports from China was mainly driven by economic reasons, to reduce the bilateral trade deficit. Five years later, the tariff issue remains unresolved, and as the 2024 election year approaches, Biden may face greater political risks in removing tariffs than in keeping them. Although removing tariffs would curb inflation, the impact is dispersed and relatively small, affecting core PCE by only -0.2pp.

Against the backdrop of tense China-U.S. relations, the tariff issue has not been resolved, and the focus has shifted to technology and investment areas. During the Trump administration, the restrictions on China mainly targeted telecom companies such as ZTE and Huawei, while the Biden administration has further added some Chinese companies in sectors such as supercomputing, surveillance technology, aerospace, drones, etc. to the entity list and military-industrial sanctions list, to prevent providing U.S. technology to companies related to China’s military or surveillance policies.

Last October, the U.S. announced a ban on exports of advanced semiconductor technology (including chips, equipment and related software) to China. Although U.S. policymakers have mentioned the possibility of regulating other strategic sectors (such as biotechnology/biomanufacturing), semiconductor regulation will have the largest macro-level impact - expected to bring nearly 2% cumulative shock to China’s GDP in the next few years. The U.S. has also conducted intensive reviews of Chinese investments in the U.S. through the CFIUS (Committee on Foreign Investment in the United States) process, especially for social media platforms with ties to China (such as TikTok).

In response to U.S. tariffs, technology and investment controls, China is committed to building its own ecosystem, expanding markets and investing in new technologies. It focuses on developing electric vehicle batteries and semiconductor sectors, seeks multilateral trade agreements and market diversification, and shifts some production capacity for the U.S. market to countries and regions that are not affected by tariffs, such as India and Southeast Asia. At the same time, China is reducing its dependence on the dollar, promoting the use of renminbi in international trade (with countries such as Russia, Brazil, Saudi Arabia, etc.), and gradually increasing its gold reserves.

Analysis of China-US Decoupling

Although all of the focus of Sino-U.S. competition over the past six years has been on trade wars, bilateral trade has remained at extremely high levels with support from U.S. household consumption patterns. On the investment front, FDI from U.S. companies and other G7 economies to China has declined, with about 80% of total FDI inflows into China over the past three years coming from 10 U.S. (mainly tech) companies and 10 European (mainly automotive and chemical) companies. Therefore, only a few well-known super giants continue to increase their bets (such as Europe’s L’Oreal, Nestle), partly in order to get ahead of possible new U.S. investment restrictions; most other companies are taking a wait-and-see approach and are cautious about making additional direct investment expenditures in China.

China’s FDI to the U.S. has also not returned to near its highs in 2015/16, mainly due to concerns about capital outflows from Beijing but also increasingly due to security considerations from Washington. Both sides have set lower ceilings for Sino-U.S. contacts through FDI channels.

However it is undeniable that China and America are still each other’s most important trading partners. Among them, China accounts for 7.6% of America’s total exports, ranking third after Canada and Mexico; it accounts for 18% of America’s imports, ranking first.

U.S. exports of agricultural products to China reached a record high in 2022 at $30 billion; other categories dependent on exports to China include chemicals ($25 billion), petroleum ($11 billion), food ($3.8 billion) and minerals ($2.3 billion). The largest import item from China for the U.S. is electronic products, totaling $161 billion, accounting for 23% of total imports.

Although the U.S. is working to make its supply chain more diversified, U.S. companies still rely heavily on Chinese manufacturers and consumers. Several major U.S. giants have more than a fifth of their total revenue in China, especially semiconductor companies such as Qualcomm, Nvidia, Intel, etc. We believe that it is difficult for U.S. companies to easily withdraw from the Chinese market, and at the same time, given that China has the world’s most efficient, well-equipped and relatively low-cost manufacturing environment, it is difficult to be completely transferred to India or Southeast Asia in a short period of time.

We believe that China and the U.S. still have deep economic ties, and complete decoupling is unrealistic in the short term. Even moderate decoupling is costly for both economies, with losses expected to be in the trillions (Canada’s GDP is only $2 trillion a year). In comparison, as China is in the early stages of globalisation and is an export-oriented country, it will suffer more losses than the U.S.

China's investment value

As China fails to achieve its growth target for the first time after the reform and opening up, some investors have begun to question whether China’s economy is suffering from long-term structural problems. This, coupled with escalating geopolitical tensions, has potentially changed the external perception of China.

In the past few decades, China has experienced many cyclical ups and downs, mainly driven by two factors: market cycles and policy cycles. Geopolitical tensions have become the third factor driving fluctuations in investment patterns. The trade-off between risk and return has become more challenging, but we believe that China is still worth investing in, especially resilient companies in today’s environment.

As Europe and the U.S. are still facing high inflation and interest rates, potential systemic risks in the banking sector and other impacts, China’s macroeconomic environment is quite different, partly because of U.S. efforts to decouple the two economies, and partly because of the pandemic changing China’s business cycle. Today China has very low inflation and interest rates, and is experiencing a strong economic recovery, likely to be one of the main drivers of global growth this year. Compared to other regions, investing in China offers a reasonable risk-return trade-off. MSCI China currently has a P/E of 10.3 times, lower than the historical average of 13 times.

We are optimistic about the following four investment themes.

First energy transition: China is making smooth progress and receiving strong attention from the government, involving power generation, distribution, storage and significant investments in the grid.

Second advanced manufacturing: In the past China was labor-intensive and low-cost manufacturing, but in the past decade or so, China has emerged as a leader in several advanced manufacturing sectors such as electronics, machine tools, robotics, fine chemicals and raw materials.

Third global supply chain adjustment: Driven by countries’ desire to achieve supply chain diversification and companies’ desire to build more resilience in their supply chains and move manufacturing activities to lower-cost locations. This behaviour is not limited to multinational companies but also involves Chinese companies that have strong expertise and large amounts of capital to build new facilities outside their domestic markets.

Fourth consumption and health care: When McDonald’s first opened in China in 1990, per capita income was less than $400; by 2022 this figure had exceeded $12,000. China has now become one of the world’s largest consumer markets and the second largest pharmaceutical market after the U.S.

Investment Ideas and Advice

Since 2018 when trade wars between the two countries first became a focus point, Sino-U.S. tensions have been an important factor affecting returns on Chinese assets. Since then, the scope of tensions has evolved and extended to technology transfer restrictions, corporate sanctions, delisting concerns around Chinese ADRs (American Depository Receipts), portfolio flow restrictions. Currently $550 billion worth of goods exported from China to the U.S. are subject to import tariffs; more than 1,200 Chinese companies (mainly in defensive and TMT sectors) are on various U.S. restriction lists; PCAOB (Public Company Accounting Oversight Board) must regularly inspect audit files of Chinese ADRs to continue listing in the U.S.; advanced U.S. semiconductor technology is banned from being exported to China.

Although bilateral tensions/market-implied concerns are at historical highs and have been reflected in valuations of China’s offshore market - Hong Kong stocks currently have a P/E lower than emerging market (EM) averages - investors require higher risk returns as China ends its zero-tolerance policy; there are signs of resumption of high-level exchanges between China and the U.S… Former Fed Chairman and current Treasury Secretary Yellen recently said that strengthening economic exchanges with China is very important and hopes to visit China at an appropriate time this year with Commerce Secretary Raimondo.