Awakening the dragonHow trade disputes may accelerate China's technology growth
February 27, 2019
Historically, the emerging markets small-cap equities asset class has provided access to many of the fastest growing consumer opportunities in the world. Trade tensions between the United States and China contributed to emerging market stocks declining 14.6% and Chinese stocks falling 18.8% during 2018 (Source: MSCI). Going forward we think it’s important to remind investors to maintain a long-term view. In our opinion, we are currently witnessing a potential change in the global landscape, which could provide significant shareholder returns over time in emerging markets small-caps, as China dedicates resources toward building out advanced technologies such as semiconductors, manufacturing, artificial intelligence (AI), and biotechnology.
Below we discuss how China may be reacting to the current trade challenges and how technological innovation is creating substantial opportunities ahead.
Trade tensions clearly remain a point of uncertainty for investors. However, we believe there are potential unintended consequences of many US trade positions. China’s recent trade disputes with US leaders over companies like Huawei and ZTE (see sidebar) have been a wakeup call to Chinese leadership. We believe the national security spat with these companies, for example, may be accelerating China’s build-out of key technology industries. Chinese leaders likely realize that the country can no longer be at the mercy of the global technology supply chain. Technology is now a national security issue for China. Access to advanced chips and telecommunications equipment is seen as crucial to future economic development and stability. Currently, China is mostly dependent upon imports in this area.
China’s Made in China 2025 plan, which has garnered criticism from many US leaders (see sidebar), is a result of these concerns. Chinese leaders increasingly recognize the need to innovate, commit to new levels of research and development, and build a homegrown network of component parts suppliers across a variety of industries. With all the support that the Chinese government is putting into tech research and development, and the advancements that China has established in quantum technology, AI, and other future technologies, we believe it is not a stretch to say that the next “Silicon Valley-style” boom could come out of China, leading to many years of exciting investment opportunities.
While the market is often focused on the negatives around trade tensions, we believe there may be increased opportunity for companies in several key areas, simply given the accelerated change that is now occurring in China.
Semiconductors, energy, and pharmaceutical/medical are three sectors worth examining in brief, for their dynamics and overall potential.
Estimates of the size of China’s growing middle class of consumers vary greatly, but range as high as 400 million people based on China’s government statistics. Certainly, a new generation of Chinese consumers is coming online, which brings an insatiable demand for memory and semiconductors.
China consumes 59% of the world's semiconductors but produces roughly just 16%. Per policy, the government’s goal is to see that, by 2025, 70% of all semiconductors consumed in China are made locally, and to that end China has committed $150 billion toward building out its domestic semiconductor industry (source: US Chamber of Commerce).
At the World Economic Forum in Davos, Switzerland, Huawei announced the deployment of its new 5G chipset technology in 10 countries, expecting to grow the list to 30 countries over the next 12 months despite international restrictions the company now faces. Many analysts point out that a shift to fully homegrown semiconductor production will not be easy and may take China years. That said, Dow Jones and Reuters have reported that the Beijing-backed “Big Fund” for chip development raised as much as $32 billion in one month alone last year. And that Huawei invested more than $13 billion in its research and development in 2017, the most of any Chinese company.
China’s Belt and Road Initiative (BRI) includes a goal to link the energy infrastructure of up to 65 countries. Over the past five years, according to 13D Global Strategy & Research, Chinese companies announced $102 billion in investments to build or acquire power transmission infrastructure across Latin America, Africa, Europe, and elsewhere. China’s long-term vision includes linking Europe’s power grid to China.
Modernization of China’s own energy networks is Phase One in its plans to create a global, renewable energy grid across continents, that would give China the potential to dominate world energy markets. As the world leader in ultra high voltage transmission technology, China has blown past the US in this area, which led the US energy secretary in November to call the trend a “Sputnik moment” for the US.
Pharmaceutical / medical
Another sector in which China exhibits forward thinking is pharmaceuticals and healthcare, where China is seeing new-technology applications make a positive contribution. Chinese leaders, in our view, see the need for greater independence and safety of supply over time in this industry as well.
In 2018, China went through several rounds of reform aimed at raising national drug regulations to international standards. In September, its national regulatory body (comparable to the US Food and Drug Administration) was renamed the National Medical Products Administration — the latest in a series of 2018 steps aimed at building confidence in standards, creating increased regulatory transparency, and encouraging greater collaboration with the rest of the world.
China is home to an aging population with significant medical needs, and Chinese companies are innovating, adopting mobile healthcare and other technology-based solutions. This makes the country a leader in the adoption of digitalized medicine.
Small companies poised for growth
The rate of change in these sectors of China’s economy can be expected to fundamentally transform the investment landscape over the next decade. Massive investment is flooding into these key strategic areas and naturally there will be companies that benefit and win, and losers that get overrun. Data show that many of these industries have large-cap global champions, yet the leading companies in the same space in China are still small or mid-caps — so the runway is long.
We especially see opportunity in the small-cap space, given that China’s market is not dominated by mega-cap players like in the US. For example, the largest communications equipment company in the US is Cisco, which had a market capitalization of $225 billion as of Feb. 26, 2019. By comparison, China’s largest listed company in this space is ZTE, at $18 billion in market cap (Source: Bloomberg).
When we consider the sheer size of China’s markets, given a 1.38 billion population, the magnitude of the growth opportunity is clear. The chart below lists the largest US and Chinese listed companies across various industries. Capital flows into these areas in China over the next decade will have huge implications for small caps, as this wide disparity is unlikely to last in our view.
A story just beginning
As emerging markets small-cap managers, we are closely following developments in the ongoing trade negotiations. While we’re cognizant of the risks presented by the trade war, we aren’t taking our eyes off the bigger picture and the massive opportunities that are still present within many important sectors.
Our approach is focused on identifying fundamental change in companies with significant growth potential. As we look out over the next decade, we see a type of change that we haven’t seen in the past century. We’re optimistic about the opportunities and changes that China’s plans will create. While trade will continue to dominate the headlines, as investors we are continuing to seek the best and most compelling opportunities arising from these changes.
Growth by policy
To understand China’s development, it’s important to understand the China Communist Party’s economic vision and growth policies. Much has been reported about the following two initiatives especially.
Made in China 2025
Under Made in China 2025, China aims to rapidly expand its advanced technology and manufacturing sectors, with goals of achieving greater self-reliance and a leadership role in key technologies. The plan supports China’s ongoing effort to generally shift its economy away from drivers such as mining and low-wage manufacturing (such as consumer-goods assembly) and toward high-tech industries that should in turn drive higher rates of productivity.
Made in China 2025 is intended in part to help China avoid the often-discussed “middle-income trap,” an economic phenomenon often seen in developing nations, where the trajectory of economic growth plateaus once wages rise.
Among the many stated goals of Made in China 2025, the following two are notable: reaching the status of advanced manufacturing leader within a decade, and becoming the world leader in AI by 2030, with the aim of valuing the AI industry at 1 trillion yuan (source: The Wall Street Journal, China). Observers including the Office of the US Trade Representative have noted that Chinese leaders including President Xi downshifted public rhetoric around the policy in 2018, but that Made in China 2025 continues to drive much of China’s trade policy, and development planning.
Belt and Road Initiative
Arguably the best-known of China’s policy-based development initiatives, the Belt and Road Initiative (BRI) is President Xi’s ambitious trade plan that involves massive infrastructure building to connect Asia and Africa, to Europe in multiple ways. By some estimates, the BRI could cost 12 times what the US spent on the Marshall Plan following World War II, and it endeavors to reshape globe trade and raise the living standards while touching 76 trading-partner countries.
Based partly on a 21st century envisioning of ancient “silk road” trading routes, the BRI promises to connect China to the world’s markets, consumers, and suppliers by both land and sea. As trade disputes with the West became amplified, the plan encountered a growing share of international critics focused on China’s debt lending associated with BRI infrastructure development. The sheer size of the effort means that it continues to influence much of China’s state business and economic policy.
Trade disputes between the US and China came to a head in 2018, and nowhere did adversarial positions become more established than with two technology companies: Huawei and ZTE.
Suspicion around Huawei, its networking equipment security, and the potential for misuse have led to the company facing restrictions in North America, Europe, and Japan. Suspicions and accusations about the company’s role in spying have led to some level of international intrigue that has underpinned the nature of the current trade debate.
The ZTE dispute as a seminal event
US leaders in 2018 took measures to strengthen its Committee on Foreign Investment in the US (CFIUS) with an eye on bolstering security and defense, by reining in forced technology transfer — a major issue in the ongoing trade negotiations. In the case of ZTE, the Chinese company was blocked by the US Commerce Department in April 2018, but in June agreed to pay a fine of $1 billion and bring an American monitoring team on board to resolve its disputes.
As noted in our commentary, US treatment of ZTE served as a severe wakeup call for Chinese leaders who are keen to see the country develop world-leading technology companies. The treatment of ZTE made Chinese leadership recognize the need to innovate, commit to new levels of research and development, and develop its own, autonomous network of component parts suppliers across a variety of industries. In this view, the treatment of ZTE was a seminal event, and the trade dispute is driving Chinese manufacturing innovation and the maturation of its supply chains.
IMPORTANT RISK CONSIDERATIONS
Past performance does not guarantee future results.
Investing involves risk, including the possible loss of principal.
The views expressed represent the Manager's assessment of the market environment as of February 2019, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
This content is for informational and/or educational purposes only and is not an endorsement of any app, service, or publicly traded company.
At time of publication, Huawei and ZTE were not holdings of any mutual fund or separate account managed by the author and the Macquarie Investment Management Global Ex-US Equity team.
International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.
Investments in small and/or medium-sized companies typically exhibit greater risk and higher volatility than larger, more established companies.
Narrowly focused investments may exhibit higher volatility than investments in multiple industry sectors. A sector is a segment of the economy that includes companies providing the same types of products or services. Although companies within a sector tend to be reasonably consistent in their fundamentals, these fundamentals may differ substantially from one sector to another. For example, some sectors are cyclical, rising and falling with changes in the economy while others are defensive, maintaining their strength despite economic ups and downs.
Healthcare companies are subject to extensive government regulation and their profitability can be affected by restrictions on government reimbursement for medical expenses, rising costs of medical products and services, pricing pressure, and malpractice or other litigation.