Last year delivered continued economic prosperity for the United States, yet it was also a period of elevated uncertainty. Two predominant factors driving global markets were the gradual tightening of monetary conditions and escalating trade disputes.

Over the past couple of years at Altfest, we have been positioning our portfolios to anticipate tighter monetary conditions, including a rise in global funding costs. For instance, in early 2018 when fresh money was still chasing the emerging markets, we dialed down our exposure to those holdings because of our concerns about the impact that higher interest rates can have on these developing economies’ trade and fiscal balances.

The speed and intensity at which the trade war with China unraveled shook up the confidence of global investors. This may result in economic growth below potential in the short term. However, investor pessimism also created opportunities through an apparent disconnect between valuations and fundamentals in certain pockets of the market, especially EM Asia, where we restored increases to our positions in late 2018. Both our downsizing and upsizing of EM exposures last year have paid off well, one by protecting from the downside sell-off and the other by participating in the upside rally.

Capitalism “with Chinese Characteristics”¹?

Headlines often portray the trade war with China as a phenomenon of the Trump presidency. In reality, the dispute has been brewing for decades, beginning with China’s entry into the World Trade Organization (WTO) in 2001. After the end of the Cold War, the West saw China’s accession into the WTO’s system of global trade rules as an opportunity to reshape the remains of communism into a democratic mold. The economic rewards of gaining access to such a large, untapped market were also substantial.

It was also hoped that the benefits of open-market capitalism gradually would nudge the Chinese toward a more transparent political system, where the rule of law prevails and fair and equitable treatment of human rights acts as a guiding principle. From the very beginning, Chinese leaders appeared to have been cynical about the potential cost of belonging to the WTO, and have resisted attempts to open their economy in a meaningful way. Nevertheless, the country has since evolved from an insulated economy saddled with low productivity to a protectionist capitalism fueled by modern technology and intense state planning.

The West has accused² that the development of China’s innovation-centric economy has come at the expense of forced technology transfers, appropriation of intellectual property, and manipulation of currency, among other things. Chinese protectionist policies have been cited as harmful to U.S. workers and industries, holding middle-income Americans back from improved living standards. Meanwhile, amid a rise in populism across global democracies, China is promoting its state-controlled capitalism as an alternative to free-market democracy.

Toward A Level Playing Field

“Keep a cool head and maintain a low profile. Never take the lead — but aim to do something big,” said Deng Xiaoping, a pioneer of late 20th-century market reforms in China. Today, however, Chinese leaders appear to be uncharacteristically vocal in displaying their ambition to take a more authoritative role on the global stage. Whether through the sprawling infrastructure project known as the Belt and Road Initiative, the China 2025 move to produce higher-value products and services,³ or assertiveness in the South China Sea region, China has started projecting its economic and military strength.⁴ The rise of an affluent demographic and increased technological prowess justifies China’s desire to take a more crucial role in global geopolitics.

Despite its economic ascendance, China does not appear keen to give up the special accommodations that were extended to encourage its participation in the global trading system. From the West’s point of view, China today no longer needs the favorable terms and conditions usually given to the poorer emerging economies to encourage participation and development. Given China’s colossal market stature in the global economy today, it does not come as a surprise that a more level playing field in terms of trade reciprocity is expected by its developed-economy trading partners.

A Long and Arduous Process

China is thought to have bent, if not broken, many of the norms that form the basis of the WTO rulebook along the way to its modern prosperity. Up until now, due to the multiple intricate facets involved, China’s violations of WTO regulations rarely have been publicly scrutinized as closely. Last year marked the year of escalation of those gripes and grievances, driven by President Trump’s refusal to accept long-term trade imbalances across several industries. Reaching an agreement that actually addresses the underlying concerns of both nations and other developed economies will likely be a long and arduous process. In the post-Soviet era, China did demonstrate great flexibility in reshaping its economy by steering toward a capitalistic system. It is plausible that, at this juncture, it may gradually reform itself toward being an open-market economy – an outcome that would bode well for the global economy as a whole.

Together, China and the United States make up about 40 percent of the global economy,⁵ with many intricate linkages throughout the global supply chain. Consequently, a prolonged conflict will result in significant stress to the global economy, and could roil financial markets and affect investments. It is likely that compromises will be reached, and some interim measures put in place to stabilize global business and financial market conditions while a lasting long-term solution is sought. As we navigate the unknown, our job as investors is to remain analytical at all times, avoiding sentiment-driven decision traps while staying nimble so as to improve our portfolios’ risk-reward characteristics.

 

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Sush Poddar, MBA, is an Investment Strategist at Altfest. Prior to joining Altfest, she was an Executive Director at a large investment bank. She holds an MBA in International Finance from Thunderbird School of Global Management at Arizona State University.

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References: ¹http://www.chinadaily.com.cn/china/19thcpcnationalcongress/2017-11/04/content_34115212.htm;  ²https://www.whitehouse.gov/wp-content/uploads/2018/06/FINAL-China-Technology-Report-6.18.18-PDF.pdf; ³https://www.uschamber.com/sites/default/files/final_made_in_china_2025_report_full.pdf; ⁴https://cfrd8-files.cfr.org/sites/default/files/report_pdf/Patricia%20Kim%20-%20Testimony%20on%20China%20Military%20Expansion%20-%20HPSCI%20May%2017.pdf; ⁵https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=US

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