A New Cold War? The Deteriorating Relationship Between China and The US

Commentary

July 8, 2021 — Our job as investment analysts is, by necessity, to attempt to look over the horizon. But as Yogi Berra famously said, “It’s tough to make predictions, especially about the future.” A necessary device for the adept analyst is ascertaining where there might be blind spots in consensus investor views. Though most investors seem to have come to terms with the change in the US-China relationship, I believe many are still not fully appreciating the accelerating nature of deterioration in the relationship. Further, I think most investors are severely underappreciating the potential implications, both near-term and long-term, that this deterioration may have on their investments.

Many investors were caught off balance by the seemingly sudden shift in US policy towards China during the Trump administration. Capstone spent much of last year warning clients that the change in policy was not peculiar to the Trump administration, but instead the new status quo. In a powerful sign of this, the U.S. Senate passed a bill in June that would direct more than $250 billion into advanced technology research aimed at countering China. Proof that urgency to counter China is bipartisan came in the final Senate vote: 68-32. The Biden administration has made it clear that they have no intention of deviating from the Trump administration’s aggressive stance towards China. “The period that was broadly described as engagement has come to an end,” Kurt Campbell, the US coordinator for Indo-Pacific affairs on the National Security Council, said recently, adding that “the dominant paradigm is going to be competition.”

Politics is also acting as an accelerant to the deteriorating relationship. In the US, Fox News and other conservative news outlets are submitting President Biden to relentless accusations of being soft on China. Our sources in the White House suggest the administration will meet these accusations with policies that are at least as tough as the Trump administration, if not tougher. The White House political strategy is to do whatever it takes to prevent Republicans from being able to outflank Democrats on China. In other words, the more Republicans accuse Democrats of being weak on China, the more aggressive Democrats will become. The number one US policy at the recent G7 meetings was to convince allies to join the US in a tougher policy towards China. In future political campaigns, the two parties are likely to attempt to out-do each other in their bellicosity towards China. This political dynamic creates a slippery slope.

Although foreign policy wonks, and certainly CEOs, are loathe to call the present situation a “cold war,” it is getting harder to see it as anything else. If the status quo is not a cold war, it is difficult to find policy experts who believe that is not where it is headed. This fact is poorly understood by investors. Most in the corporate world continue to act as if a return to the good old days of engagement and unfettered commerce between China and the West is inevitable. This stands in stark contrast to the views of any policymaker, on either side of the aisle, that I have spoken to in the past year. If it is true that the West is entering a period of cold war with China, then investors must analyze the economic implications. There was little trade or commerce between the West and the Soviet Union during the last cold war. What will happen to the sales of companies such as Apple (16% sales to China), Intel (21% sales to China), and Qualcomm (46% sales to China) if the West engages in a cold war with China?

What is worse than a cold war? A hot one. On June 15th of this year, 28 Chinese military planes, including advanced fighters and nuclear-capable bombers, entered Taiwanese airspace, the largest in a series of recent incursions. In fact, there have been more than 380 such incursions since the start of 2020. Many experts believe that such acts are not mere shows of force, but a prelude to an invasion. President Xi Jinping has repeatedly stated that reunification was necessary to complete his vision for a modern China. As recently as this year, the Chinese Foreign Minister said that the use of force to achieve reunification would never be ruled out. Our contacts in US national security circles suggest that a Chinese invasion of Taiwan is rapidly moving up the list of priority threats. The US pursues a policy of “strategic ambiguity” towards its commitment to defend Taiwan from an invasion, intentionally making the Chinese guess to what extent we would intervene. Considering the last decade’s massive upgrade in Chinese military capabilities, most military planners believe there is nothing the US could do to stop China from invading. This simple fact increases the risk of China acting. Although the loss of life and Taiwan’s sovereignty would be the real tragedy, investors will also have to consider the impact on their investments in China and Taiwan. Clients should consider hedging this risk with Taiwan index futures and options, which are amongst the most liquid in the world.

Capstone analyzes this issue from many angles. I work with Daniel Silverberg, who until recently was the House Majority Leader’s national security advisor, conducting analysis on the Biden team’s policies. Capstone Senior Advisor Tom Feddo, until recently assistant treasury secretary for Investment Security (CFIUS), advises clients on the CFIUS and sanctions implications of China investments. As always, our technology team led by JB Ferguson covers the investment implications of changing China policy on the global technology sector. Finally, we are planning several in-person policy days in Washington, D.C. to allow our clients to speak directly with the Biden administration on these critical topics.

— David Barrosse, CEO