Collaboration, Rivalry, and Tension – Moneyweb

The initial official treaty between the United States and China was established in 1844 under rather dubious circumstances. Following Britain’s considerable gains from the Qing Empire during the First Opium War, the United States sought to secure similarly advantageous terms.

This culminated in the Treaty of Wangxia, signed between a burgeoning power, the US, and a faltering one.

The treaty granted the US access to five treaty ports (Guangzhou, Xiamen, Fuzhou, Ningbo, and Shanghai), where Westerners enjoyed special privileges, including extraterritoriality, which particularly angered the Chinese, as it meant Westerners accused of crimes could evade trial by Chinese authorities.

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This marked the beginning of a period referred to in China as the “century of humiliation,” characterized by a second Opium War, a Japanese invasion, civil war, and the communist revolution in 1949.

In stark contrast, last week’s meeting between Presidents Donald Trump and Xi Jinping in Beijing took place in a much friendlier atmosphere, resulting in declarations of camaraderie and collaboration.

Nevertheless, significant underlying tensions persist.

Currently, China is the resurgent entity contesting the US’s position as the sole global superpower. China maintains strong ties with Russia, opposing Western support for Ukraine, while being Iran’s primary customer.

Taiwan remains a crucial point of contention, with China adamantly advocating for eventual reunification, while the US backs the current status quo.

The crucial role Taiwan plays as the world’s top producer of advanced semiconductors places it at the forefront of the artificial intelligence (AI) boom, adding to the complexity of the situation.

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The US has been striving to maintain its lead in AI and other technologies by restricting China’s access to high-end chips. Conversely, China excels in many technologies related to the green transition, being the largest producer of solar panels, batteries, wind turbines, and electric vehicles.

Essentially, it is the Saudi Arabia of clean energy, and with AI being incredibly electricity-heavy, this might ultimately provide it with an edge.

China also dominates 80% to 90% of the global supply of several “rare earth” minerals, essential for a variety of military and industrial technologies, granting it substantial bargaining power in negotiations with any nation, including the US.

The world’s factory

Indeed, China is overwhelmingly the largest producer of numerous goods essential to global markets, both basic and advanced technologies. Consequently, its trade surplus (exports minus imports) has reached unprecedented levels, exceeding $1 trillion last year.

This narrative means echoes from the past.

The Opium Wars compelled China to accept drug imports from Britain and other colonial powers.

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While the Western world desired Chinese products, the preference wasn’t reciprocated, leading to a significant flow of gold and silver eastward [China accepted payment only in precious metals]. Forcing China to import opium at gunpoint—after colonial powers got its population addicted—had devastating social consequences and was a strategy to redress the severe trade imbalance.

Similarly, Trump introduced tariffs on China during his first term to address the modern trade deficit, and his successor, Joe Biden, mostly maintained these measures.

Hardline stances on China have become a rare bipartisan issue in Washington.

During his second term, Trump escalated these efforts, at one point imposing tariffs on Chinese goods as high as 145%. After negotiations, exemptions, and ultimately intervention by the Supreme Court, the actual tariff on Chinese imports is now about 25%, still considerably higher than before.

As a result, exports from China to the US have significantly dropped. At its height in 2017, nearly a quarter of US goods imports by value originated from China.

By April of this year, that figure had dwindled to just 8%, although there may still be a considerable amount rerouted through third countries like Vietnam.

While much of the world has not followed Trump in raising trade barriers against China, it doesn’t imply they are not eager to.

Industries across Asia, Europe, and beyond are experiencing substantial pressure from Chinese imports. The automotive sector has been particularly affected as China transitioned from a car importer to the largest exporter by volume in recent years.

China’s exports and imports by value

This impressive export strength, alongside the relative decline in imports, indicates a shift towards domestic brands.

However, the trade surplus also obscures a weakness: a lack of domestic demand. This is partly a conscious choice.

As widely known, China’s economic model structurally favors investment over consumption, leaving households with a smaller share of national income compared to nations at a similar developmental stage.

Simultaneously, significant resources were allocated to developing world-class infrastructure and manufacturing capabilities. Yet a substantial portion of this investment was funneled into residential real estate, culminating in an epic bubble that burst in 2022.

The aftermath of the property bubble continues to reverberate throughout the economy. A decline in apartment sales means fewer purchases of fridges, televisions, and beds, a good portion of which would have been imported.

If imports had matched exports, Chinese consumers could have acquired an additional $100 to $200 billion worth of foreign goods.

Instead, consumer confidence remains historically low, although slightly improved compared to a year ago.

Chinese consumer confidence

Yuan too few

Another factor behind import weakness—and export strength—is an undervalued currency, a long-standing grievance of the US government.

A nation with such a substantial trade surplus would typically see upward pressure on its currency. Even after some recent appreciation, the yuan remains generally weak on a real trade-weighted basis.

China real trade-weighted exchange rate

A weak currency typically enhances exports and constrains imports, which is why Trump advocates for a softer dollar and a stronger yuan.

Such a shift would help balance the trade relationship between China and the rest of the world, while increasing the purchasing power of Chinese households, allowing for more foreign goods, services, and overseas travel.

The yuan’s exchange rate is managed by the People’s Bank of China (PBOC), making its level a deliberate choice rather than an inevitability.

While it makes sense for the yuan to be allowed to appreciate gradually over time, the PBOC generally prioritizes stability above all else.

This brings us to a final comparison between the US and China regarding equity markets. Although China can confidently present itself as an economic, military, and technological superpower, market valuations tell a contrasting story.

Conversely, despite discussions about US decline during Trump’s erratic administration, the S&P 500 has consistently achieved new record highs, even in the face of ongoing geopolitical tensions.

Forward price-earnings ratios

Chinese equities are trading at a significant discount compared to US counterparts, especially when considering that the yield on a 10-year US government bond was just under 4.5% last week, while China’s equivalent was only 1.7%. This suggests a considerable ‘equity risk premium’ in Chinese stocks, whereas US equities show little margin of safety.

Some of this disparity can be attributed to unpredictable regulatory changes that led to China being labeled “uninvestable” around 2021. However, in the time since, authorities have shifted their stance towards Chinese equity markets.

Historically, Beijing has viewed equity markets as secondary, viewing speculation as less critical than funding economic development through the banking system. Yet, banks are now constrained by a struggling property sector, and the successes of other nations, particularly the US tech sector, have demonstrated how equity markets can support innovation and business growth while also creating wealth for households, which is vital in a nation experiencing an aging population and uneven social security coverage.

Hence, regulators now aim to cultivate a “slow bull market” with steadily increasing equity values to foster economic growth and aid Chinese families in saving for retirement.

To achieve this, corporate governance standards have been improved, and publicly listed companies are encouraged to distribute regular dividends, representing a much-needed shift towards a more shareholder-friendly environment.

Despite China’s impressive economic achievements, publicly traded companies have struggled to convert GDP growth into profit growth, leading to underwhelming equity returns. In contrast, the primary reason the S&P 500 commands a premium probably lies in its consistent earnings per share growth, outpacing other major markets.

The profitability of China’s industrial firms has been further hindered by overcapacity and fierce competition, issues policymakers are addressing through “anti-involution” initiatives.

For equity investors beyond China’s borders, the combination of a depreciated currency, low valuations, and heightened policy support is likely to be attractive.

China’s representation in the main global equity indexes compiled by organizations like MSCI and FTSE Russell has dropped to around 3%, disproportionate to its contribution to global economic output and innovation.

Nevertheless, risks persist.

China’s unfavorable demographic situation is widely recognized, primarily as a result of the now-repealed one-child policy. Last year saw only 7.9 million newborns, the lowest count since the Communist Party’s rise to power in 1949.

Read: China’s population grew older and richer … [Jun 2023]

While life expectancy has considerably increased—now surpassing that of the US, a remarkable achievement—this fails to mitigate workforce shrinkage and will inevitably constrain long-term GDP growth rates (again, for equity investors, profits matter more than GDP).

This trend may also stimulate innovation and technological adoption.

According to the International Federation of Robotics, China accounted for half of the world’s industrial robot installations in 2024, with the majority supplied by domestic companies for the first time.

China’s strategy regarding artificial intelligence appears to focus on practical usage rather than pursuing cutting-edge models, contrasting with Silicon Valley’s winner-takes-all ethos.

Time will reveal the effectiveness of either approach.

Total debt-to-GDP ratios

A significant concern is the high total (encompassing household, government, corporate, and financial sector) debt levels, which exceed those of the US when expressed as a percentage of GDP. Notably, the pace at which this debt has increased is clearly unsustainable.

China possesses a far higher savings rate than the US or any other large economy, with most of the debt being internal.

Thus, the issue is more about internal distribution than existential crises. However, in a slowing economy, servicing this debt becomes challenging, and someone must bear the resultant losses.

A substantial risk lies in the US-China relationship.

Both nations are actively working to decrease dependence on one another, with China potentially at an advantage. However, the economies are still deeply intertwined, making the notion of complete decoupling unrealistic.

Consequently, a sharp rupture over Taiwan or other flashpoints could lead to a significant market sell-off, impacting markets worldwide, not just within China.

If the US were to implement sanctions against China, any financial institution would need to adhere to them or risk isolation from the dollar system.

The US retains considerable leverage in this matter, which is well understood by China.

Such a conflict would be detrimental for all involved, making last week’s summit between Trump and Xi critical, even if it yielded no groundbreaking policy shifts or resolutions on contentious issues.

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While friendly gestures don’t solve deep-rooted disputes, they ensure that channels of communication remain open. The strategic rivalry between the world’s superpowers is inevitable, but it can be managed.

Ultimately, both sides—and the entire world—stand to lose if this rivalry escalates into outright conflict.

Izak Odendaal is an investment strategist at Old Mutual Wealth.