Will U.S.-China tensions have a material impact on client portfolios?

Will the soured U.S.-China relationship have a material impact on client portfolios?

The short answer is yes.

Relations between the two countries are at their lowest point since the normalization of Beijing and Washington in 1979. Over the past few years, the two world’s largest economies have clashed over trade, intellectual property rights, territorial claims and even consulate closures. Just recently, the U.S. ambassador to China, Terry Branstad, announced he will be stepping down. Since July 2018, the U.S, has delivered four rounds of tariffs, accumulating more than $360 billion of Chinese goods, while China has retaliated with tariffs on more than $110 billion of U.S. products.

The tension has not gone unnoticed by investors. On September 3, the Nasdaq Composite tumbled nearly 5%, the worst day for stocks since June. With the improving U.S. COVID-19 outlook, many analysts attributed the sell-off to souring U.S.-China relations. Other market watchers say continued tension will lead to financial decoupling, which could have severe consequences for publicly traded companies in both countries.

What does this mean for advisors and their clients? For one, they should scrutinize the tech holdings in their portfolios.

Though U.S. tech stocks took on safe-haven status during the coronavirus pandemic, it is possible some stalwarts could see revenue decline if tariffs rise or China targets Apple and other US tech firms in retaliation for the Huawei chip ban from the Trump Administration. Since 2018, American companies have lost at least $1.7 trillion in stock value due to U.S. tariffs against Chinese imports, according to recent research by economists from the New York Fed and Columbia University.

Even as economists, politicians and policy wonks bicker over the long-term impacts of China-U.S. tension, one quintessential question remains for financial advisors: Can planners seeking alpha afford not to invest in emerging markets like China? After all, advisors and institutional investors alike, look to emerging market investments in Asia and China in particular, to diversify portfolios and gain more yield.

When looking to deploy clients’ assets, Asia is front and center for many financial advisors due to China’s strong equity markets and the dynamic growth in the region says Kevin Chen, the Chief Economist at New York based RIA Horizon Financial. The MSCI China All Shares Index, ytd is up 22% which is in stark contrast to the S&P 500, up a mere 3.9% during the same period.

Still, worries persist. Brandon Allen, co-founder and managing partner of TXV Partners, a VC firm based in Austin, Texas, says he’s wary about investing in Chinese companies listed in the U.S. This is largely due to concerns over political and economic reforms; President Xi Jinping has been elected for life, coupled with an opaque economic and financial system, despite impressive growth.

In 2019, around 150 China-based companies with a total market value of $1.2 trillion were listed on U.S. stock exchanges. As more China-based companies have listed, there has been growing concern about the lack of transparency into accounting and governance standards of Chinese firms, which policymakers have warned put U.S. investors at increased risk because of the inability of the Public Company Accounting Oversight Board to inspect audit work and practices of PCAOB-registered auditing firms in China. Moreover, critics argue that China-based companies listed in the U.S. have an unfair advantage compared with American firms as they can circumvent the accounting and governance standards to which U.S. corporations are subject to. The most recent Luckin Coffee scandal is a case in point.

The world's second biggest economy reported that its first quarter GDP contracted by 6.8% in 2020 from a year ago due to the coronavirus outbreak. But its gross domestic product still showed a V-like recovery in April — faster than analysts had expected and significantly faster than the recovery of the U.S. and other global economies. That being said, according to the World Bank’s China Economic Update Report, China’s heyday of double-digit annual growth is gone. The economy has slowed, there is growing income inequality and the population is aging.

So what does all mean for advisors? A rising geopolitical rival i.e. China + an enduring power like the US = volatility in markets, especially running up to and even after the US election.

Wall Street's trusted barometer of investor anxiety, the VIX index is currently trading around 26, having peaked as high as 69 during the height of the coronavirus markets crisis in mid-March. When you combine that with low treasury yields indicate that the next two months and throughout 2020 will see increased volatility across sectors like tech, healthcare, pharmaceuticals, commercial real estate and especially the airline industry. Financial planners need to factor this into their portfolio construction and analysis.

Declining US-China relations are also expected to take a toll on IPO markets. The Trump administration is considering rules that could delist any Chinese company on American stock exchanges if they fail to follow the U.S. accounting and audit standards by January 2022. Also, earlier this year, the Senate approved the Holding Foreign Companies Accountable Act, which requires the U.S.-listed companies to certify they are not under the control of foreign governments. Once the regulations kick in, fewer Chinese companies are likely to list shares on U.S. exchanges.

There's a high probability that Chinese companies may delist from U.S. markets and relist elsewhere, especially, domestically on Chinese markets such as Hong Kong, Shanghai or Shenzhen exchanges. The biggest consumer market in the world lures those companies and capital from the U.S. For instance, JD.com, one of the top Chinese companies listed in NASDAQ, raised $ 6.6 billion on the Hong Kong Stock Exchange as its secondary listings in June. In addition, according to Reuters, the Shanghai stock exchange on September 11th accepted JD.com's fintech affiliate's application for a listing on its Nasdaq-style STAR Market.

One early indication: Jack Ma’s Ant Group, which has the potential to be the world’s largest IPO to date, is filing dual listings in Shanghai and Hong Kong exchanges, citing geopolitical tensions. As U.S.-China financial decoupling appears to have deepened, listings on the NYSE and Nasdaq have gradually lost attraction for Chinese tech companies.

Some argue the U.S. maintains the upper hand as China imports a significant portion of chips from Silicon Valley. However, China has made significant efforts toward technological self-sufficiency. In light of U.S. export restrictions, Beijing has committed an estimated $1.4 trillion by 2025 in key sectors including 5G, artificial intelligence and data centers.

During this election year, the political infighting between Democrats and Republicans has expedited worsening ties between the U.S. and China. Many leading Democrats share Republicans' deep concerns over China's increasingly assertive authoritarianism. Moreover, each party wants to demonstrate how their economic plan will benefit the U.S. economy and thus take a harder stance on China’s infringement of intellectual property rights as it pertains to U.S. companies. Better supporting US market access in China will continue to be important rallying points.

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Also, Wall Street and markets are not pricing in a potential conflict in the Taiwan Straits or a possible skirmish in the South China Sea. But if tensions between the U.S. and China intensify, markets will have to confront these realities.

White House officials, Congress and American society at large, do not fully understand the magnitude or the catastrophic economic impact of full financial decoupling between the U.S. and China.

As financial planners strive to add more value, they must keep abreast on geopolitical events and explain to clients how these have, and could, impact financial markets, portfolios, 401k’s, 403B’s, endowments etc., on a practical level. More importantly, advisors need to calibrate these risks and opportunities carefully when evaluating portfolios and asset allocations as this will create best practices in differentiating exceptional financial advisors.

With additional reporting by Jeeho Bae and Mingxuan (Danny) Du.