“Uncertainty always creates doubt, and doubt creates fear.” — Oscar Munoz, Chief Executive Officer of United Airlines
“When the uncertain future becomes the past, the past in turn becomes uncertain.” — from Moth Smoke by Mohsin Hamid
We revisit the trade dispute between the US and China this week. We apologise in advance for the lengthy quotes from pieces we wrote last year but felt it necessary to provide context.
Note: We have split this week’s commentary in two parts as it runs quite long, the first part is below and the second will follow by Friday this week.
In December of last year in The Hawks Have Not Left the Building we wrote (emphasis added):
[W]e do not expect a breakthrough in negotiations to materialise during the next round of talks between Washington and Beijing before the suspension of the increase in tariffs lapses. As long as hawks such as Peter Navarro and Robert E. Lighthizer continue to have President Trump’s ear our view is unlikely to change. If, however, the dovish members of the Trump Administration, such as Treasury Secretary Steve Mnuchin and Director of the National Economic Council Lawrence Kudlow, begin to take control of proceedings we would become much more hopeful of a positive resolution to the trade dispute.
For now, we see the temporary agreement between the two sides as providing much needed short-term respite for China. More importantly, we see President Trump’s offer of a temporary ceasefire without President Xi offering any concessions on sensitive issues, such as industrial policy, state funded subsidies and intellectual property rights, to be a symptom of the short-termism that seemingly besets democratically elected leaders without exception. Had the US equity capital markets not faltered recently and / or the Republicans not lost control of the House of Representatives, it is unlikely, we think, that President Trump would have been as acquiescent.
The above quote provides the frame of reference from which the remainder of the analysis in this piece stems from.
Semiconductors: From Bad to Worse
The below chart compares the performance of the S&P 500 Index to that of the Philadelphia Semiconductor Index $SOX and the ADR of Taiwan Semiconductor Manufacturing Company $TSM over the course of the last month.
President Trump first tweeted about the trade negotiations with China falling apart on 5 May. Markets sold off a little in response to the tweet, semiconductor stocks sold off more. Then things got worse for semiconductor stocks, the US government issued an edict banning American suppliers from doing business with one of their biggest customers, Huawei Technologies Company, without the explicit approval of the US government. And then got even worse, the South China Morning reported that Huawei allegedly has been stockpiling a year’s worth of inventory out of fear of export ban being placed on US manufacturers. If true, US chipmakers’ earnings last year were much inflated.
Following the negative news, and striking a fear into markets that the Trump Administration was willing and able to inflict direct harm on US corporations in its bids to rein in China, government officials have come out suggesting that a handful of temporary exemptions may be granted. This would give some suppliers and customers of China’s telecom giant a 90-day reprieve from tough trade penalties.
From Fragile to “Antifragile”…
On 6 June 1967, Arab oil producing nations, to deter nations from supporting Israel in the six-day war, placed an embargo on oil exports to the US, UK and a number of other western nations. At the time the embargo was imposed, the UK was wholly dependent on foreign on oil resources and was, unsurprisingly, severely impacted by the embargo.
Between 1969 and 1970, vast oil reserves were discovered by the UK under the North Sea.
Then again in 1973, Organization of Arab Petroleum Exporting Countries proclaimed an oil embargo targeting the US, Canada, the UK, Netherlands, Japan and South Africa. The embargo was targeted at nations perceived as supporting Israel during the Yom Kippur War. The price of oil shot up from US dollars 3 per barrel to nearly US dollars 12 globally.
In 1973, the UK was still a net importer of oil and felt the sting from the Arab oil boycott. By 1979, on the back of the strength of the North Sea discovery, UK had propelled itself to become a net exporter of oil.
Just as the Arab oil embargoes spurred the UK’s discovery of North Sea Oil and eventual energy independence, the actions of the Trump Administration are almost certainly going to harden China’s resolve in developing a captive semiconductor industry.
President Xi Jinping has during his reign recounted the long and painful history of China surrendering to British imperialists in the nineteenth century, often referred to as the “century of humiliation”. Neither he nor his comrades at the Chinese Communist Party will want China’s dependence on US chipmakers to become a source of humiliation or an impediment to its growth ambitions. China has no choice but to invest in developing a captive semiconductor industry capable of competing with the best and brightest.
…But Achieving Antafragility Takes Time
From the original Arabian oil embargo, it took the UK a further eleven years to build up its oil production capabilities and to free itself from any future oil exporter hostilities.
China, too, will need time to develop its captive semiconductor industry. Huawei’s alleged hoarding of a year’s worth of supply of American manufactured inventory proves as much.
China’s semiconductor industry remains far behind its American and Korean counterparts in the manufacture of advanced processing chips. The challenges is further compounded with non-existent local production of the equipment that is required to design and fabricate advanced processing chips.
Semiconductor companies are now hostage to the vagaries of the American and Chinese trade dispute. Should some semblance of a trade agreement be miraculously salvaged semiconductor stocks will most likely rally and rally hard. If not, they might be in a long, painful ride.
The Huawei Question
Huawei, not for first time, is suffering at the hands of the US political establishment.
In January 2018, AT&T, pressured by Washington, walked away from a deal to sell the Huawei smartphone, the Mate 10, to customers in the United States just before the partnership was set to be unveiled. Verizon shortly followed suit.
Meng Wanzhou, CFO of Huawei and daughter of the company’s founder, was arrested on 1 December 2018 in Canada at the request of the US government for allegedly defrauding multiple financial institutions in breach of US-imposed bans on dealing with Iran.
In February 2019, US officials lobbied European authorities in banning Huawei from 5G network builds in Europe and called the Chinese company “duplicitous and deceitful”.
By forbidding US companies from trading with Huawei, one of China’s most prominent technology companies, without the government’s explicit permission, the Trump Administration is clearly sending a message. And the ban is not just limited to US companies, export controls also extend to non-US companies that sell any product in which US-origin technology comprises 25 per cent or more of the value. Given in the intertwined nature of semiconductor production, implying that Huawei is likely unable to replace US products it loses access to.
The question now is whether the Trump Administration goes for the kill or not. ZTE had to cease operations after being hit with US export controls, Huawei is likely to suffer same fate unless US officials make a u-turn. Given the heavy criticism President Trump received for rolling back sanctions on ZTE, it is unlikely that he would be as forgiving this time around with US elections next year unless he wants to revive the trade deal.
The fate of Huawei is now likely to signal the outcome of the trade deal:
1. Huawei survives and retains most of its pre-export glory and we get a “beautiful” trade deal.
2. Huawei survives but in a scaled back form and we get a patched up trade deal with both sides saving face.
3. Huawei fails and the trade deal is dead, or at least takes a very long-time to revive.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.