The New Cold War With China
The first Cold War was between the United States and the Soviet Union and it lasted from 1947 to 1991. The Next Cold War, also known as the New Cold War, has various starting points. At the earliest, one could say it started with President Nixon’s visit to China in 1972. Or it started the year China was admitted to the World Trade Organization (2001). Or the year China stopped pegging its currency to the dollar (2005). The New Cold War is now in full swing, fueled by comments from President Trump and President Xi each representing a bigger point of no return for China. US investors have to consider the reality of investing in China in 2020.
Like Eastern Europe after World War II
The Chinese have adopted the Cold War playbook from the Soviet Union after the end of World War II. This time Hong Kong is on the receiving end of China’s oppression. Now that the Coronavirus is in decline, Chinese control over this global financial hub continues. Proposed laws for Hong Kong that outlaw subversion and sedition represent further Chinese interference in Hong Kong’s long-standing rule of law. If enacted, the laws will drastically change the promise of “one country, two systems” on which Hong Kong’s capitalistic, free-market economy was built. China’s combative rhetoric is typical Cold War talk, backed up by Cold War action. President Trump is largely powerless to stop China geographically since both sides agree no weapons or armies will be used.
Current threats from China
The cold war today is not just about tariffs on goods. For the first time in history, the US is not a clear leader in a major technological sector – 5G technology, the next generation of telecom networks. This technology has the ability to underpin future innovation. The two Chinese telecom giants, Huawei and ZTE, account for about 40 percent of the global 5G infrastructure market which is expected to serve as the backbone for trillions of dollars’ worth of economic and industrial activity in an increasingly digital global economy. The equipment manufactured by these two Chinese companies has become the key battle between the two nations. American intelligence officials claim that these companies could pose a threat to national security and are urging other nations to not use their systems. While some countries, like Australia, have heeded the U.S. warnings, others like the United Kingdom and Saudi Arabia continue to work with Huawei.
One principal concern is that by using these complex 5G systems, we could be opening back doors to valuable or sensitive communications data. Recently, the U.S administration banned Huawei’s access to global chip makers that use U.S. technology. The move largely affects Taiwan Semiconductor Manufacturing (TSM), which makes advanced chips for 5G smartphones; Huawei is the largest customer for those Taiwan Semi chips. China in return has promised retaliation. Nokia and Ericsson are the only other global competitors. U.S. efforts to catch up with China on 5G—and the inevitable Chinese pushback—could force the rest of the world to choose sides in a tech cold war.
Huawei and ZTE deny their connection to the Chinese government. The reality is, China does not recognize shareholder freedom or independence. It is not possible for any Chinese company to verify they are independent from the Chinese government.
We have been losing ground, and we are fighting back
Already we can see how the US is resisting the use of next-generation Chinese 5G investments. Attorney General William Barr described China’s dominance of 5G telecom networks as one of the top U.S. national security and economic threats. Just yesterday a Canadian judge upheld the arrest of the Huawei CFO in Vancouver, opening the way for her to be extradited to the US. She is the daughter of the founder. What other major public companies have had their CFO’s arrested and extradited?
Multinational delivery companies like Amazon, Walmart and Costco are increasing their US suppliers at their own expense and at the expense of Chinese companies. We know there is a higher price to pay for an all-US system and we seem ready to pay it.
The Chinese government has duplicated the US successes in computers, broadband, and social media and has deliberately excluded US companies like Google and Facebook from operating in China. Their tech leaders get a lot of attention and praise as the next big global investment opportunity. However, Alibaba and Tencent have been flat for four years and Baidu is down 50% from its 2018 high.
Investors are a bit spoiled in the US because we don’t have to worry about the US government dominating or controlling our major companies. AMZN, FB and AAPL must operate under the rule of law, and those laws can’t be subverted at will by our government officials. Chinese companies, on the other hand, are inseparable from the Chinese government.
There is no international rule of law governing that your shares of BABA or BIDU actually represent shares in the underlying company. When you buy BABA, you are buying shares in a holding company in the Cayman Islands meant to represent shares of the company in China. Even though you can easily buy and sell shares of Chinese companies in your brokerage account, you have close to zero shareholder rights as an investor.
Shareholder rights are not a typical concern of US investors and therefore we feel that the average investor is largely unaware of this difference. If the goal is to keep and grow long term wealth, investors in Chinese companies ought to consider the added uncertainty of owning shares that can be manipulated at any moment by the Chinese government.
China has an insatiable need to grow for at least 30 years because of its massive, aging population. For a current look at the US policy toward China see The United States Strategic Approach to The People’s Republic of China published on the White House website. The position paper is a hard look at the reality of US-China relations. There are many points of conflict and there is a clear US policy of ‘America first, world first’.
Rethinking supply chains
Even before the current crisis began many companies had begun to diversify production away from China to other countries. This was mainly driven by the need to avoid U.S tariffs. This pandemic has forced us to reassess globalization and our supply chains from building materials to essential medications.
The bottom line
China is the 2nd largest economy in the world and is home to many leading global corporations, especially in technology. While this may seem enticing to investors who have an eye on the future, we feel that too many investors are overlooking the added risks in investing in these Chinese companies. The tail risks include strange results like a sudden delisting or mass fraudulent accounting (Luckin Coffee is a recent example). Both would result in immediate significant losses. With some exceptions (Enron in the 90’s) these types of risks are not present in many other equity investments in the US and elsewhere. Fortunately there are many ways to source investment returns. It’s always better to be aware of the risks even if they don’t materialize.