The China Syndrome

By David Nelson, CFA
Ukraine – The fight for survival and the horrors of a conflict half a world away hasn’t been lost on equity markets. Stocks were challenged even before the invasion as the Fed was preparing to launch an aggressive policy of raising rates while at the same time reducing a massive balance sheet. Already elevated, energy and commodity prices were pushed higher as economic sanctions now include cutting off as much Russian oil and natural gas imports as can be tolerated by western economies.

Data by FactSet

The increased risk to the food supply and potential famine in some parts of the world later this year adds to the concern. All of this is taking place as Americans bear witness to graphic images of atrocities and war crimes leaving thousand’s dead, injured or missing.

Pivot to China

Without losing focus of what we can and must do to keep the above from spinning out of control, America needs to pivot to China or risk being blindsided on two fronts of the economic war.

Companies by definition are driven by bottom line thinking and adjust policy within a framework of laws and regulations to grow profits. However, even more important is economic survival and increasingly China as both a customer and partner is moving from asset to liability.
Ten years ago, the political machine was all in on China. U.S. businesses hailed it as an outsourcing miracle offering cheap labor and increasingly sophisticated supply chains. The economic potential of western multi-nationals to tap into a rising middle-class added to the appeal, giving the Washington lobbyists everything they needed to sell the story.

Today that story has turned into a nightmare as Americans read daily of an increasingly hostile President Xi who has embraced his relationship with Putin and Russia saying it has no limits.

The New Cold War

This weekend the Wall Street Journal points out that China is shifting policy to beef up its nuclear arsenal in part because of what they view as an increasingly likely conflict with the United States over Taiwan.

All of this is of course on the heels of decades of increased intellectual property theft and an unlevel playing field when it comes to economic access. TikTock continues to be a controversial social media company with access to millions of Americans and yes, their wallets. However, Meta (FB) and Twitter (TWTR) have been blocked in China since 2009.

The above has been well vetted by journalists and analysts for years but today the risks are shifting to something more immediate. China’s zero covid policy has forced officials to shut or lockdown entire cities threatening large manufacturing hubs endangering global supply chains even further.

The New York Times article in February highlights that despite a massive inoculation effort they still haven’t embraced mRNA technology developed in the West and embraced by dozens of countries. The Times continues to report that last year they said they would approve western vaccines but months later went their own way. To date that looks like a huge mistake.

As President Xi continues his march toward lifetime control his decisions have become more chaotic and desperate ushering in a new cold war.

The shutdowns without question will have a decided economic impact on their GDP as risks continue to rise for the west.

Technology at risk

Technology and growth have been the hands down winner in the U.S. for most of the last 15 years. That leadership was already threatened as rising rates became a challenge for long duration equity. Most valuation models start with the risk-free rate and as that rises investors demand lower valuations for those same cash flows.

However, these new risks out of China are an increased challenge for U.S. technology companies. Nowhere is this felt more than in the Semiconductor industry which has significant revenue exposure to the Chinese mainland.

Qualcomm Revenue Exposure to China

Data by FactSet

Qualcomm (QCOM) is perhaps the poster child with over 65% of revenue exposed to the region. They aren’t alone. On average the exposure at the industry level is probably north of 25%

Apple (AAPL) doesn’t escape either coming in at 17% not to mention the importance of their manufacturing footprint.

Data by FactSet

The good news is that a lot of these risks are reflected in current valuations with many semi stocks trading with single digit forward PE ratios and free cash flow yields between 5-8%. To date investors don’t seem to believe the discounts are large enough with the SMH leading the way lower, now 22% off the highs last year vs the broad technology basket down just over 14%.

In light of these near-term challenges and an increasingly dangerous adversary, the sentiment toward China and calls to bring manufacturing and supply chains back to the homeland are louder than ever.

Sensing a rising tide of anger hear in the U.S. as China positions themselves on the side of a Russian sociopath, both sides of the political aisle are becoming increasingly hostile toward Beijing.

Speaker Pelosi tests positive for COVID

speakerLast week China said that a planned trip by U.S. House of Representatives Speaker Nancy Pelosi to Taiwan would be crossing a red line and warned of a significant impact to Chinese-US. Relations. Subsequently, Speaker Pelosi tested positive for COVID, and the trip was cancelled.
Did we blink? We’ll find out in the weeks ahead and whether or not another trip is planned.
In any event the U.S. needs to shore up relations with our regional trading partners who are becoming increasingly threatened by China and a leader seemingly more focused on his own destiny than those of his country.
*At the time of this article some funds managed by David were long AAPL and FB.