The Russia-Ukraine war has further underlined deep differences between the US and China. We believe their escalating strategic competition will create potential investment opportunities.

Tensions between the world’s two economic superpowers – the US and China – have increased in 2022. The Russia-Ukraine war has highlighted the “G2” nations’ geopolitical and ideological differences. Amid strong words and sanction threats from both sides, China’s President Xi has said the standoff between countries over their alignment in the Ukraine conflict could be more damaging to world peace than the war itself.

The US-China divergence over Ukraine is merely the latest development in their momentous struggle. China is seeking to become the dominant power in its home region and beyond. We call the standoff resulting from this challenge to US hegemony “G2 polarization.” The struggle is playing out in many different spheres, including in trade, financial markets, technology, military capabilities and diplomatic influence.

We have long argued this rivalry would continue to intensify with each side trying to advance its own interests and block the other – see Is your portfolio ready for a G2 world? in Mid-Year Outlook 2019. And we continue to believe it has important implications for the global economy and for investors’ portfolios.

What to know about the US-China relationship

The G2 powers’ current rhetoric is harsh. At the end of April, the US House of Representatives passed the AXIS (Assessing Xi’s Interference and Subversion) Act. This requires the US State Department to provide updates to Congress on China’s backing of Russia over Ukraine. In response to US attempts to strengthen ties with Southeast Asian nations, China has warned the US not to provoke confrontation.

Despite the prevailing mood, we expect near-team stability in US-China relations rather than strife. We do not believe China will suffer sanctions for continuing to trade with Russia, at least until inflation settles down. Amid the supply shock and rapidly rising prices, avoiding further disruption to trade relations is key for the US and others. For its part, China realizes that its economic interests are much more tied to those of the West than to Russia, so will probably limit aiding Russia in the conflict.  

By the same token, we do not expect any major near-term improvement in US-China relations. There is potential for progress on various issues, including reducing tariffs and easing Chinese access to US capital markets. A lowering of tariffs on Chinese imports would be welcome for both US consumers and investors alike. However, it could also be a political liability for the ruling Democratic Party in November’s elections. So while there are deals to be done, they may have to wait until after 2022.

Taiwan remains an obvious potential flashpoint between the G2 powers. President Xi has stated reunification “must be fulfilled” and has not ruled out using force against what China considers a wayward province. However, the resistance Russia has encountered in Ukraine and the massive international sanctions backlash may have given China’s authorities pause for reflection.

Currently, China is preoccupied with COVID, the economic hardship from lockdowns and the upcoming 20^th National Congress of the Chinese Communist Party. Given all this, any near-term conflict over Taiwan is unlikely.

Ultimately, the Ukraine conflict has accelerated G2 polarization. However, we also believe that this intensifying rivalry does not make a full-blown conflict between the US and China inevitable. Our base case remains that tough but peaceful strategic competition remains the likeliest outcome.

Chinese equities could see meaningful upside

G2 polarization is closely related to what we describe as the unstoppable trend of the rise of Asia. This describes the long-term shift in global economic power from West to East, driven by the region’s urbanization, growth of the middle class and advancements in homegrown technologies. As the region’s largest economy, China is central to this trend.

China’s aim is for domestic consumption to become its key driver of economic growth for the coming decades, rather than the external demand it has relied upon hitherto. COVID – and the strict lockdowns imposed by the Chinese authorities – have hindered this shift. We believe consumption’s potential is huge but realizing it will require further growth and difficult policy reforms mainly in three areas, although each have seen patchy progress.

• Broadening and deepening universal medical coverage, as well as an overhaul of the pension system, so that households may amass less precautionary savings and spend more – figure 1.
• Rural land reform to enable more financial transactions and agricultural productivity could also enrich rural populations, triggering more consumption. However, we see limited political will to expand the current pilot project nationwide.
• Further opening-up of Chinese financial markets to outsiders could help bring about innovative financial products that could help unlock the substantial wealth invested in property and allow more people to spend beyond their current incomes.

 

Figure 1. Lofty savings rate = potential consumption

 

Chart shows net household saving as a percentage of household net disposable income. Source: Haver Analytics, as of May 2021.

 

Near term, China’s draconian anti-COVID measures will likely produce economic contraction for the second quarter of 2022. To try to offset this, the authorities are in easing mode, with credit expansion and fiscal stimulus already exceeding 2020’s levels. In the second half of 2022, we believe relaxing lockdowns and additional stimulus could produce a strong rebound. This prospect could drive a recovery in Chinese equities, which are currently trading on distressed valuations – figure 2.

 

Figure 2. Credit expansion may lead equity valuation recovery

 

Source: Bloomberg, as of 17 May 2022. Past performance is no guarantee of future returns. Real results may vary. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only. All forecasts are expressions of opinion, are subject to change without notice, and are not intended to be a guarantee of future events. See Glossary for definitions.

 

Southeast Asia - economic outlook 2022

China’s tough lockdowns have reinforced another key dimension of our G2 polarization thesis. We believe US-China polarization will benefit Southeast Asian (SEA) economies, as they stand to win more business from many developed nations diversifying their supply chains away from China. At the same, time we see SEA doing more business with China.

Factory shutdowns and transport restrictions amid China’s lockdowns have highlighted the supply chain vulnerability that heavy reliance on China can cause, especially if Chinese policy becomes less predictable. Some parts suppliers to leading tech companies and electric vehicle makers, for example, are adding more capacity in SEA and India to mitigate China-related risks.

Unlike in China, SEA’s economic recovery from COVID shutdowns is well underway. Given its reliance on tourism, SEA may see further recovery in services, as restrictions on foreign visitors relax. Philippines and Thailand were among the earliest to reopen their borders, followed by Singapore, Vietnam, Indonesia and Malaysia. Despite bouncing from near zero, visitor numbers are still below 10% of 2019 levels, indicating further recovery potential.

Lastly, major commodity exporters such as Indonesia and Malaysia are benefiting from higher commodity prices induced by Russia-Ukraine conflict. Indonesia has the world’s largest nickel reserves, a key material for electric vehicle batteries, and is attracting investments from leading battery makers.

Manufacturing exports have surged more than 60% versus pre-COVID levels. Meanwhile, Malaysia is the main oil exporter in Asia, while Singapore is the major refiner.

Rising challenges to China’s long-term prospects

We observe that global investors frequently have too little portfolio exposure to Asia – or none. As economic power continues to shift eastwards, we think this can prove an increasingly expensive mistake. We also believe that today’s market conditions may offer a potential opportunity to rectify this.

Given Chinese equities’ distressed valuations, we see rebound potential this year. Among the areas we find attractive are those linked to economic reopening, green energy and technology more broadly. Across Southeast Asia, we favor investments linked to tourism, natural resources and industrial diversification away from China. The rise of Asia is set to continue. Is your portfolio oriented to this unstoppable trend?