October 10, 2020

Author: Tim Phillips

Uncover - Geopolitics investing

It’s no secret that the US and China are not exactly on the best of terms right now. The two global powers have clashed on everything from trade and intellectual property to the South China Sea and Hong Kong’s autonomy.

More recently, issues ranging from ByteDance’s forced sale of hit app TikTok in the US and Walt Disney Co’s (NYSE: DIS) controversial filming of Mulan in the infamous Xinjiang region of China have highlighted the deteriorating bilateral relationship.

All this drama got me thinking about how we position ourselves when we invest with a global mindset. Typically, the smart advice is to “ignore the noise”, particularly when it comes to politics.

However, I think the conventional wisdom on this is changing – particularly now that we are investing in a world with two veritable superpowers. Post-World War Two, investors had gone through a period of broad prosperity where the US was the sole hegemonic global power.

Even with China’s ascension to the World Trade Organisation (WTO) at the start of the 2000s, the country was just trying to rise to become a middle-income economy. It wasn’t anywhere close to challenging the US, in terms of GDP, technological advancement or global dominance.

Modern-day balancing act

Of course, fast-forward to today and things are a lot different. China is the world’s second-largest economy, has an exceptionally advanced technology sector and now clashes much more often with the US government.

This has created dilemmas for corporations operating in China, particularly American ones. Disney’s latest travails are just one example. The “House of Mouse” was criticised due to filming, and thanking the local government in the end credits, for the new blockbuster Mulan.

A few select scenes ended up being filmed in the controversial region of Xinjiang, China, where local Muslims are allegedly being held against their will in “re-education camps”.

Yet Disney isn’t the first to have to tread a fine line between upsetting their home market or the Chinese government. There was a furore in late 2019 when the general manager of the NBA’s Houston Rockets tweeted support for Hong Kong protestors.

This led to a national ban on the broadcasting of Houston Rockets games by China’s state-owned television – a ban that is still in place today as the NBA season resumes with its ongoing play-offs.

Weaponising consumers

As investors, we shouldn’t forget that foreign companies – and their shareholders – have previously faced the fallout of being on the wrong side of geopolitical disagreements.

Back in 2017, when South Korea and the US agreed to construct a so-called Terminal High Altitude Area Defense (THAAD) system, the Chinese government deemed this an unacceptable threat to their national security.

Its national tourism administration promptly instructed travel agencies across China to stop selling group tour packages to South Korea.

Furthermore, one Korean company associated with THAAD, Lotte Corp (KRX: 4990), was fined over advertising practices in China and forced to shut down department stores over apparent “fire-code violations”.

Lotte wasn’t the only company to be caught up in the spat. Other Korean firms that rely on Chinese spending, such as cosmetics makers, hotels and tour operators, all got hammered as revenues plunged.

Yet, unsurprisingly, this is part of a pattern that is seeing Chinese consumers become increasingly “patriotic” in their spending – particularly so on the back of US-China tensions.

On the flip side, the US government can be just as arbitrary when dealing with Chinese companies. We’ve seen that with the whole fiasco over the forced sale of ByteDance and how US sanctions have crippled telecommunications network equipment giant Huawei.

Going local, not American

In fact, post-Covid-19, consumers in China are increasingly going “local” with their preferences. This is seen as a nod to supporting the local economy.

Shaun Rein of China Market Research Group (CMR), a well-known expert on Chinese consumers, says that the moat enjoyed by foreign brands in China in previous years is quickly being eroded.

That’s because consumers are happy and willing to buy domestic brands, even in areas such as sportswear, diapers and infant formula. The one exception to this, he says, is luxury – where European names (and not American ones) dominate.

Implications for investors

How we view the world as US-China tensions continue to boil over is critical to how we construct our portfolio.

My own personal preference has been to avoid companies within the US that rely on China for any meaningful amount of overall revenue. The same can be said for any Chinese holdings (with respect to US revenues) you have as well.

It wouldn’t be beyond the realm of possibility to see the Chinese government “make life difficult” for a Starbucks Corporation (NASDAQ: SBUX), Nike Inc (NYSE: NKE) or Apple Inc (NASDAQ: AAPL) in the country.

This could either come in the form of targeted bans or “violations” or encouraging Chinese consumers to buy local coffee, sportwear goods, smartphones etc.

Nike makes about 18% of its revenue from China while Apple derives about 17% of its revenue from the country. For Starbucks, China is its second-biggest market after the US. This is a risk that investors need to be cognisant of when buying American companies.

Just as Huawei, ByteDance and Tencent Holdings Ltd (SEHK: 700) have recently been used as pawns by the US in the geopolitical game, I’m just surprised that it hasn’t already happened to American companies in China. It’s only a matter of time before it does.

For investors looking at the long term, the US-China decoupling is, I believe, an unstoppable trend that we should suitably position ourselves for.

In that respect, “buy American” revenues and “buy Chinese” revenues, by all means, but beware of buying any overlap of the two.

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