Since the U.S.-China trade war began in 2018 with tit-for-tat tariffs, frictions between the two nations have flared in technology and finance. In addition, with the sanctions on Russia and escalating tensions over Taiwan, geopolitical considerations likely will gain more weight in investment decisions.

While this situation poses rising geopolitical risks for investors compared to the past era of globalization, our medium-term baseline still expects mutual economic and financial interests between these two large economies will offset political pressures to act more quickly and dramatically. Instead, we anticipate a gradual trend of manufacturing and supply chain shifts over the next several years, balanced by mutual interests to maintain access to each other’s large domestic markets.

Supply chain diversification: inevitable, but likely gradual

The trade war disrupted trade flows between the U.S. and China in 2018-19, and reverberated along global supply chains. However, the COVID-19 pandemic caused wider damage to the global manufacturing sector, and subsequent stimulus packages across countries actually boosted demand for Chinese exports.

China’s export capacity has since been tested repeatedly, through waves of domestic COVID-19 outbreaks, lockdowns, power outages, and regional geopolitical conflict. Exports have not only remained resilient, but China had also gained trade market share during the pandemic. Despite surging global commodity prices and an elevated domestic Producer Price Index (PPI), China has managed to keep its export prices competitive – in fact, they have risen much less than U.S. import prices from elsewhere.

In addition, it may take years for substitute markets to catch up, considering the complexity and capacity of supply chains, as well as market reforms needed to facilitate manufacturing and exports. Meanwhile, the export sector, being labor-intensive, remains key in supporting domestic employment, and thus China would strive to maintain its stability.

Therefore, while supply chain diversification is inevitable, we believe the process will be gradual given the reliability and affordability of Chinese goods, especially in a high inflation environment.

Implications for investors

Looking forward, we expect the rivalry between China and the U.S. to continue, but we believe this will be a gradual process. The stickiness of the supply chains, the large Chinese consumer market, and the intertwined financial systems make an abrupt decoupling an expensive proposition. The process is unlikely to be a linear one and we expect headlines and volatility, which can create large valuation gaps as prices diverge from fundamentals.

In such an environment, we see opportunities in select high quality Chinese credits with robust balance sheets and resilient business models to withstand the macro volatilities. An example would be the auto sector, especially new energy vehicles, where the companies cater largely to domestic demand and would be less impacted by tariffs. Green industry and selected (non-sensitive) tech players also present opportunities given the secular trends of decarbonisation and digitalization.

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