In his book from 2013, The China Choice, professor Hugh White wrote:
Even a relatively minor conflict between America and China would have immense consequences. It would probably change the nature of the relationship fundamentally and permanently.
Rivalry might raise sovereign risk to the point where investment and trade decisions started to shift. At such a point, companies from each country will have to factor in the risk of conflict or political disruption in deciding whether to invest in the other country, or lend one another money.
Seven years on from the publication of his book I believe we have reached that point. It is now time to factor in the risk of conflict or political disruption into investment decisions.
The coronavirus pandemic and the new national security law in Hong Kong are probably not the events Dr White had in mind, I am sure. The result, I believe, is nevertheless the same: the pandemic and full absorption of Hong Kong into the mainland has triggered a fundamental and probably permanent change in the nature of the US-China relationship.
It does seem pretty clear that obfuscation by Chinese authorities in the early stages of the coronavirus outbreak at least contributed to the severity of the worldwide pandemic, with nearly 140,000 deaths in the US alone as of this writing. Could this have been avoided with more transparency? The new national security law in Hong Kong erodes the basic freedoms the territory has enjoyed until now, essentially ending the ‘one country, two systems’ agreement.
As I write this, the US president has signed the Hong Kong Autonomy Act, which was passed unanimously by both houses of Congress. The US State Department has also rejected China’s extensive maritime claims in the South China Sea. These are very important events.
The nature of the relationship has fundamentally changed. Regardless of who wins the election in November, the clock cannot be turned back.
It is important to understand that this is not just about the coronavirus, or some street protests in Hong Kong, nor is it about Trump’s America first doctrine or his re-election. The origins of this break reach back decades. China’s long-held ambition to be the preeminent power in Asia (perhaps globally) sets it at odds to the fundamental security interests of the United States.
For observers capable of sifting the evidence and drawing their own conclusions rather than blithely accepting the official narrative, China’s strategic ambitions have been discernable for over two decades. In 1997 journalists Richard Bernstein and Ross Munro wrote:
China’s historic sense of itself, its basic material and human conditions, and its own assessment of its national interest combine to make a Chinese move toward Asian hegemony virtually inevitable.
For as long as most investors can remember, the United States and China have managed to set aside their fundamentally incompatible differences in order to pursue near term common interests. This was mostly economic growth. There comes a point, however, when the advantages for each side to be gained by pursuing common interests no longer outweigh the costs of denying satisfaction of other important national objectives.
Beijing demonstrated the primacy of its national security objectives over economic interests with the implementation of the new national security law in Hong Kong despite the obloquy of most Western governments.
Where things go from here is anyone’s guess. An effort at détente after a fractious election could calm things down for a period, but the forces at work here go much deeper and the scale and seriousness of China’s challenge only seems to have become clear to Western leaders in the past few months. The events now set in train take time to fully play out.
What does that mean for us as investors? To be clear, we rarely let geopolitical concerns sway our investment calculations. We remain focused first and foremost on trying to identify great businesses run by great management at a reasonable price to own for the long term. This is a bottom-up, company-by-company process. Yet we cannot ignore the fact that the world’s two largest economies will henceforth prioritize national security interests over economic cooperation. This has far-reaching consequences.
Geopolitical risks like a China-US de-coupling are the kind of rare, but momentous events that investors often struggle with. They present two problems. First, experience counsels that it’s best to ignore them (similar to previous pandemic-related sell offs before this one).
Second, a new geopolitical arrangement is so difficult to envision, it simply gets thrown in the ‘too hard’ basket.
For probably every investor alive today it has never paid to worry about geopolitical risk. Just ask any investor in Korean stocks that panicked and sold when North Korea fired a rocket or conducted some other form of provocation. So most investors silo their thinking; aware of the rising geopolitical issues, but unable or unwilling to incorporate those events into the investment domain.
The problem with experience is that like the turkey who gets fed day after day, one day it turns out to be Christmas.
Today’s investors may have never experienced this type of disruption, but it is also hard to argue they are actually rare. Like pandemics, geopolitical conflict occurs with depressing frequency.
If you take US and European history since the year 1700, I count at least six major conflagrations including the War of the Spanish Succession, the 7 Years War, the Napoleonic Wars, the US Civil War, WWI and WWII. That is a combined 54 years of major war over the span of just over 320 years or 17 years of conflict in every century. A near one-in-five chance is hardly remote!
The second problem is envisioning what this new investment environment will look like? Not only is it different to the arrangements that governed the last 40 years, it is likely to be different from past episodes of conflict. History may be a useful guide, but imperfect. We tend to think of cold war scenarios or the last hot wars involving planes, tanks, ships and rockets. That might be possible, but we could also be dealing with a hybrid form of strategic competition along the dimensions of economics, finance, technology, information, and influence. Thought of in that way, this conflict has probably already begun.
We don’t mean to be all doom and gloom. The case for investing in strong business franchises with pricing power, wide profit margins, high returns on capital, a reasonable growth outlook and run by capable management is as strong as ever. Investing globally, wherever the best returns are available, still makes enormous sense but will require an additional layer of thinking.
As a first practical step we are trying to ensure that the businesses we invest in are not acutely exposed to the risk of a possible US-China conflict. This may limit our options, but it’s a small cost in order to build some resiliency into our investments.