The geopolitical risks we face today are more complicated than prior regional conflicts. We believe the odds of a trigger event that will cause a cascade of impacts across global markets and the economy are rising.
New US trade restrictions on Chinese technology were expected after the bipartisan CHIPS and Science Act of 2022 signed into law by President Biden on August 9. But the extent of the export controls was startling and included dramatic restrictions on US persons working to assist China’s tech industry.
This follows a speech by Katherine Tai, the US Trade Representative, that denounced China’s "state-directed industrial dominance policies" and expressed the necessity of defending US national security interests via this aggressive industrial policy.
Commentary and the broadly negative market reaction suggest these US sanctions will not only deeply constrain Chinese semiconductor firms but reshape and potentially disrupt global supply chains.
By value, China consumes more semiconductors than it imports oil, receiving 74% of worldwide semi production in 2019. Leading publicly traded global semiconductor firms from the US, Japan and South Korea generated 27% of their revenues from China in 2022. At the same time, Taiwan fabricates 65% of the world’s semiconductors and almost 90% of the most advanced chips.
We see this act as a major new "Little Fire" (see our October 9, 2022 CIO Strategy Bulletin), further adding to the list of compounding issues affecting markets. These include, among others, rapidly rising interest rates, OPEC’s petroleum supply constraints, marked escalation of the war in Ukraine and a Federal Reserve pushing the US toward recession.
While semiconductors are essential for the economy of the future, the news bodes especially poorly for the sector that has already experienced a 43% drop in share prices this year. The decision of the US administration to limit US content in China’s computing industry – particularly advanced semiconductor equipment – was expected. But the extent and timing of the announcement, coming just before the Party Congress, was provocative.
Last week, President Biden invoked the Cuban missile crisis to describe the nuclear weapons threat from Russia. The Cuban Missile Crisis was a 35-day standoff in October/November 1962 between the US and Soviet Union over the stationing of nuclear weapons close to the US mainland. It stands as a powerful historic example of binary geopolitical risk, and is widely considered the closest the world ever came to a nuclear exchange since the end of World War II.
Within the short period of grave nuclear risk, which could have ended very differently, US equities dropped less than 10% and then regained those losses and made new highs. (Note: Financial market volatility in the early 1960s was at a significantly lower scale than what we witness today.) The world economy grew strongly from 1963-1969. The US economy grew 4.3% on average during the period, including a recession that began a full eight years later. With one short bear market to absorb, investors enjoyed robust equity market returns over most of the remaining decade.
The path of economic progress isn’t straight and continuous. Most often, recessions and recoveries drive financial market cycles. In fact, 90% of geopolitical shocks since and including WWII have not generated turning points for economic activity. The OPEC oil embargo of late 1973 proved to be a growth-constraining shock, catalyzing higher consumer prices and a world-wide recession.
The present Russia/Ukraine conflict has similarities to the Gulf War of 1990. Each of these events had significant negative regional impact and notable global effects. In every case, central banks were unable to immediately offset the inflationary impact of supply shocks no matter what their hoped-for inflation targets.
Arguably the risks we face today are more complicated than prior regional conflicts. Overlapping shocks are more likely when central banks are tightening against a weakening global economic outlook. A stronger alliance between Russia and China would be untimely and might generate new fronts of conflict.
We fear this is precisely what the US is risking with its restrictive technology actions. These increase "joint probability risk," raising the likelihood that a trigger event will cause a cascade of impacts that ripple across world markets and the economy.