Many analysts view the recent change in the relationship between China and the US as the sign of things to come. Both countries are becoming more aggressive in asserting their claim to financial, military, and geopolitical dominance. We see this as a potential for a new version of the Cold War that existed between the US and the Soviet Union. In this two-part series, we will examine the points of conflict and how they may affect your finances.
The majority of Americans’ retirement funds are invested in stocks, and in recent years, the largest share of portfolios consists of stocks in the world’s largest tech companies, like Google, Facebook, and Netflix. So much so that the strength of this stock market segment is prescribing the ability of most Americans to retire. In our opinion, tech stocks are facing one of the largest threats ever after the dot.com bubble crash, and that threat is coming from China. Here is our argument.
For an empire, it’s crucial to control the core communications axes and transportation routes. Just like the US would never give up control of the world’s sea lanes, we would never surrender control of key telecommunications infrastructure to a foreign power, such as China. Digital “goods” are becoming increasingly important, and digital data passing through cables is likely to become more valuable than physical goods transported on ships.
That is the core reason for the battle that is occurring around Huawei, the Chinese telecom manufacturer. A year ago, Australia and New Zealand announced they would ban Huawei from building their 5G mobile networks—two key US allies in the Pacific rejected Chinese technology. Then, Huawei was banned in the US from working with the government, deepening the trade war between the US and China.
But this is much more than a simple dispute about the trade of goods across borders. China’s biggest import item is semiconductors (about $260 billion a year vs. $170 billion for energy). This is a deeply vulnerable area for China since US companies hold most of the world’s important patents in this field. Should the US decide to “weaponize” semiconductor exports, it would leave Chinese policymakers with several difficult choices:
1) Should they accept that Huawei—and any other Chinese tech company—will have to accept being dictated what, where, and when to operate by the US?
2) Should they pour money and human resources into reducing the technological gap with the US in the semiconductor industry? Which brings us to an obvious question: Where would this money be poured into?
This brings to mind a remark by Ajay Kapur (VP at Bank of America Merrill Lynch), who said that countries will only have a thriving tech sector if they spend lots of money on the development of their defense sectors.
Military spending is key
Today, the US seems to be behind the most tech breakthroughs, perhaps because we spend more on defense than the next 10 countries combined. Next are Israel (who spends a big share of their GDP on their military), South Korea, and Taiwan. So, the unfolding tech war might push China to pump up its military budgets, funneling large amounts into military research. China may not crack the semiconductor code, but it can and will throw both money and people at the problem, and it has an ample supply of both.
Twenty years ago, less than a million Chinese students a year graduated from university, with roughly half of them in the sciences. The ratio is the same today, but this summer more than eight million Chinese students graduated from university. That is more graduate students than the country had undergrads a generation ago—and twice the amount of graduates in the US. Of course, scientific breakthroughs don’t depend solely on the amount of scientists, but the numbers certainly help!
The tech squeeze is coming
The US sanctions against Huawei and the expected Chinese retaliation are the worst of both worlds for US tech firms: First, the US government is telling them to say goodbye to easy access to the fast-growing Chinese market. Second, China is likely to heavily support new competitors who challenge the US tech giants. These Chinese companies won’t need to worry about their bottom line—they are first and foremost here for the benefit of national security.
In recent weeks, several US tech firms have announced that their sales outlook is worsening. This may very well squeeze the impressive performance of tech stocks.
If the US–China trade war turns into a full-scale cold war, it would rip apart long-standing supply chains, which would severely impact the profitability and productivity of US tech firms and threaten their stocks. Even worse, China’s policymakers may decide to no longer respect intellectual property rights on a more blatant scale: Chinese exports to the US and other developed markets may become so constrained that China chooses to ignore those markets and instead reverse-engineer US tech and sell it to emerging markets.
The decision of the US government to turn tech into the battlefield of the China–US cold war from a historical perspective, seems suspect.
As proven throughout history, being the battleground is no prize. Once the war is over, all you are left with are ruins. The decision to make tech the battlefield for the unfolding cold war comes because the US is holding a huge advantage in technology. But by picking this battlefield, could the US be replicating the mistakes made in the Vietnam War? We were convinced our troops, equipment, and officers were superior to the guerrilla-driven Viet Cong. We picked the battlefield, the battle took place, and the war did end—though not with the outcome the US army had expected.
The historical events of the new China–US cold war are unfolding in front of our eyes and will lead to a sharp decline in the revenue of tech companies and the valuation of their stocks. It is our opinion that you should prepare your portfolios for tech stocks paying a dear price for this cold war.