Deteriorating relations between the world’s two largest economies, at a time when the world faces an unprecedented recession, is a clear negative. Whilst China’s Foreign Minister warns of a new ‘cold war’, the US response to China’s increased assertiveness over Hong Kong has been relatively restrained so far but risks a tit-for-tat escalation and unraveling of the 2020 Phase 1 trade deal. We highlight the US companies most exposed, the complacency we see that makes the risks one-sided, and the potential headwind to US equities (SPY) best performing and largest sector, Tech (XLK). Also, why we still see Chinese equities (GXC) as a relative safe-haven.
Tensions heating up again
China has imposed a national security law on self-governed Hong Kong. The Trump administration has responded by ending its relationship with the World Health Organization; restricting entry of some Chinese nationals to the US; has said will sanction Chinese officials involved in Hong Kong decisions; and has formed a working group to look at US stock market listings of Chinese companies. No mention was made of any changes to the bilateral Phase one trade deal that took effect February 14, 2020. This follows a steady stream of recent measures raising risks on US-China relations and the Phase one trade deal, including, just from the US side:
- Passage of a Senate bill boosting oversight of foreign companies and potentially resulting in them becoming delisted from US stock exchanges.
- Nasdaq (NDAQ) announced more stringent rules on initial public offerings ostensibly to address concerns regarding recent accounting scandals.
- Department of Commerce will now require an export license for any semiconductor manufacturer for Huawei if using US software or US origin.
- Administration directed the US federal employee retirement fund, Thrift Savings Plan, to scrap planned investment in Chinese equities.
Europe and north Asian exporters exposed
We put the trade and stock-market exposures in context. US and China are relatively closed economies and stock-markets, despite being the world’s two largest economies. Overall, European and other Asian economies (such as Korea, Taiwan, Singapore) are much more exposed to a significant resumption of trade tensions or stock market volatility.
China is relatively closed. Exports plus Imports as a percentage of Chinese GDP is only 40% (half the level of Korea or Germany), whilst the stock market is among the most closed in the world, with overseas revenues representing under 15% of total index revenues. This compares to over 50% in Europe. In the US, exports plus imports as a percentage of GDP are under 30%, whilst S&P500 overseas revenues are only 30% of total revenues – low by global standards.
The twenty US companies most at risk
We screened for those large cap US companies with the largest revenue and asset exposure to China, and potentially exposed to an escalating tit-for-tat response of trade and non-trade barriers (quotas, inspections, technical standards, ‘unreliables list’). The lists are very different, reflecting those companies primarily exporting to China versus those with significant assets on the ground.
The top ten US companies by revenue exposure is dominated by semiconductor companies, led by Qualcomm (QCOM). Whilst the top ten by assets is a more diversified broad ‘industrials’ list, with a lower overall exposure, led by Yum Brands (YUM) and Air Products (APD).
Tech the potential contagion route
We also look at those US sectors with China exposure. The list is relatively short and concentrated, again reflecting the generally ‘closed’ nature of the US stock market. There are only four sectors with direct China revenue exposure (although supply chains could be another matter). Semiconductors & equipment is the most impacted sub-group when looking at the stocks list, whilst the much smaller Materials sector jumps ahead when looking on a sector basis.
The list of top twenty stocks by revenue exposure to China includes many semi industry heavyweights, including Qualcomm (QCOM), Broadcom (AVGO), Applied Materials (AMAT), and Intel (INTC). This could impact industry specific ETF’s, such as the Invesco Dynamic Semiconductors ETF (PSI) and SPDR S&P Semiconductor ETF (XSD) and be the transmission mechanism for escalation to the broader US tech sector – proxied by the Technology Select Sector SPDR ETF (XLK).
This could have broader US equity market (SPY) impact given tech is the largest (c25% index weight), and one of best performing (c0% YTD vs S&P500 index -6%), and with semiconductors accounting for c20% of the overall tech index, including two of the top-10 holdings – Intel and NVIDIA (NVDA). this is especially when combined with potential market complacency on these issues – see below.
China-exposure baskets show potential complacency
We created two indices of the US large cap stocks with the greatest proportion of China revenues and assets. The baskets were much more strongly correlated with US-China trade war events (proxied by a Google Trends index of ‘china trade war’ search popularity) than US equities. Both exhibited a -0.32 two-year correlation compared to the S&P 500’s -0.046. Interestingly, the asset- and revenue-indices exhibited the same correlation despite having little constituent overlap.
China has performed relatively well this year, and is the 2nd best performing major equity market YTD of 48 tracked globally. Looking at the lack of divergence between the stock market and our China baskets as one proxy for rising / falling tensions shows little impact so far. The below graph shows how the market is pricing in trade war risks. The higher the z-score, the less the risks are discounted, and vice versa.
This is supported by other indictors. The Google Trends index in the chart above (on ‘China trade war’) is low versus history, and the broader Trade Policy Uncertainty Index (right chart below) latest reading is 59 compared to 2018 and 2019 peaks over 250. This index measures US media mentions of trade and uncertainty.
Whilst our base case is that it is in neither parties’ interest for this to significantly escalate, especially in midst of a global recession, this analysis does imply that investors are potentially complacent, and risks very one-sided.
China was the global equity safer haven in the February-March market crash, first in and first out of the COVID crisis, with a restarting economy, macro-policy flexibility, discounted equity valuations, and good index composition. Whilst it has lagged more recently as more depressed markets have recovered off the bottom, it remains one of the only major countries globally forecast to see both positive GDP (1.2% according to IMF) and earnings growth (2.2% according to MSCI and I/B/E/S) this year. See background see our article: China the global safer-haven
China’s (Abbreviation = CN) positioning on our 26 country allocator has slipped, into the unattractive bottom-right quadrant. This means Chinese equities are relatively in-favor with investors (measuring relative fund flows, sell-side ratings, and valuation vs history) but seeing negative relative fundamental trends (relative EPS revisions, leverage to easing business cycle, and price momentum). This likely reflects the lessening of the earnings downgrade cycle in much of the rest of the world relative to China’s earlier estimate cuts. The Chinese market has also become more expensive on a composite P/E, P/BV, and P/CF measure versus its history. The consensus MSCI China 12m forward P/E of 13.7x is a significant discount to the global average 20.2x, but is also above China’s own long-term historic level.
Conclusion: Some complacency on China risks
It is an unfortunate time for world’s top two economies to risk a tit-for-tat political and trade escalation. Our base case is it remains contained, but Europe and northern Asia exporters are most exposed, along with US semiconductor stocks. Semis are a c20% of the US listed tech sector, the largest and best performing US sector year-to-date, making US-China relations relevant for the equity market. These stocks have not reacted so far to a potential US-China escalation, sowing some complacency and making risks one-sided. China remains a relative safer-haven, and almost the only major country set to see GDP and earnings growth this year.
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.