West of the Hudson

Dear Clients:

When we last visited China in December 2019, the consequence of U.S. tariffs was laid bare in a handful of conversations we had with local executives. While a common refrain included the condemnation of levies, it was the repetitive, callous U.S. rhetoric which had the greater impact on sentiment, producing both bitterness and the stated resolve to lessen its U.S. dependence. Covid revealed itself a few short weeks later and, one year on, as the bulk of the world’s economies continue to be battered, China is approaching a level of economic normalization that reflects the same spirit we noted. All the while, as the saying goes, the more things change the more they stay the same, which best sums up America’s political pandemic response. By keeping its foot firmly planted on the protectionist pedal, U.S.-Chinese relations today are unmistakably antagonistic, with trade, tariffs, access to education, jobs, and technologies firmly entrenched at the core of the dispute.

As the world’s largest economy, we were assured trade wars were “easy to win”, but there has been nothing easy about the last few years, and it is useful to review the principal issues that have made China such a formidable rival. Since joining the World Trade Organization in 2002, China’s economic growth has been an indisputable success, having done so with a particularly aggressive form of mercantilism (using state power to maximize exports). This strategy has cut their dependence on export growth by half in a single decade. Yet ~20% of China’s GDP remains export-dependent and holds them hostage to their foreign customers — none more so than the 17% of exports destined for its largest customer and now, adversary. The tightrope the U.S. walks isn’t because of the 0.5% of its exports to China, nor the critical components that U.S. firms can’t replace. It is the decades of sustained investment and billions of sunk costs building up China as a manufacturing hub. Recent data reveals that U.S. firms own over $400 billion of hard assets (property/plant/equipment) in China, and another $360 billion in Hong Kong.

Talk of economic “decoupling” has existed for years, but the term holds dissimilar meaning as the dependence is so disproportionate. For China, it’s the dependence on U.S. technologies, particularly semiconductors, whereas U.S. dependence on China is more diffuse, with supply chains heavily geared for the most efficient manufacturers in the world across an unimaginable range of products, including most technologies.

The world’s two largest economic powers were always destined to bicker, but Covid’s emergence became a true inflection point, and the pandemic-fueled year-to-date has only served to place this symbiotic relationship into greater focus. Forced closures and mass quarantining exposed the dark-side of ‘just-in- time’ production and the conversation quickly shifted to ‘just-in-case’ supply chains, with emphasis on proximity and certainty of delivery.

Ironically, another byproduct of Covid has been the surge in Chinese imports, as Americans channel money they might have spent on services like travel, movies and restaurant dining, into household items and material goods. It began with healthcare products and gained steam by stay-at-home shoppers snapping up Chinese-made furniture, appliances, and oodles of technology products to help facilitate quarantining at home. The prolonged effects of the pandemic on the U.S. and the world have served to reinforce China’s dominant manufacturing position and suggests that true economic decoupling could be a decades-long undertaking. In pure economic terms, the costs of decoupling are high, the risks innumerable, and the benefits unclear, and it is here that we jump off for this, our last quarterly letter West of the HudsonTM in 2020.

The End of Equilibrium

China is a colossus and home to 20% of the world’s population. The size and skill of its workforce and its dominant position in key sectors make it a critical player in the worldwide economy. In the last decade, Chinese GPD growth contributed ~27% of total global growth (the U.S. is ~10%). In this time, China has rapidly transitioned from its role as “manufacturing floor to the world” to the top of the value chain, creating vast prosperity and an enormous consumer market that U.S. firms do not want to lose access to. Less recognized but equally relevant, Chinese banks are the leading creditors to 66 out of 185 borrower countries, including an astounding ~50% of emerging markets. This gives the country substantial access to, and leverage over, raw materials, end-markets and, of increasing importance, geopolitical cooperation.

From what we learned in recent conversations, life across China has largely returned to normal, with low infection levels, full trains and planes, bustling bars and restaurants, and spectator sports at capacity. While many disapprove of the draconian societal means applied to slow and contain the initial viral spread, it has been a success and contrasts mightily with the botched American response. The differing response to the pandemic is a microcosm of the larger issue and, while the President demands that U.S. companies abandon their investments, translated interviews with manufacturers reinforce the idea that meaningful movement of production out of country is unlikely. The combination of China’s numerous advantages and local market access are too compelling to disconnect from and, according to a regional survey from the American Chamber of Commerce in Shanghai, fewer than 25% of the 364 U.S. firms polled said they had plans to relocate any production (just 4% are considering reshoring any production).

The message is that China’s manufacturing sector will remain the central hub for global production with its wide and deep pool of labor, modern infrastructure, dense networks of suppliers, and effective, local governments. Even during Covid that success was evident, driven by shipments of medical goods and consumer electronics, which the entire world needed all at once. Chinese firms were able to add capacity to match the demand in remarkably short order. Export growth has since broadened further as factories continue to expand and further tilt the global reliance on Chinese manufactured autos, auto parts, electronics, pharmaceuticals, medical supplies, and multi-industrial equipment.

It is this fixed and established infrastructure and co-dependence that makes switching costs so high, and why it will always be extremely difficult for the U.S. to “punish” China or completely decouple from its economic base. China’s influence continues to grow at a faster clip than any country in the world and it will only continue to accelerate. U.S. multinationals will need to remain integrated even as they outwardly contemplate diversifying certain operations and relocating finished products closer to regional end- markets, thus ensuring they are more resilient to supply shocks. Governments can of course provide corporate incentives to foster behavioral changes, but that still requires a compelling bottom-line calculus.

Focusing just on technology, how far is the U.S. prepared to push back against Chinese dominance in emerging industries like 5G, artificial intelligence, quantum computing, and fintech? Farm products and prejudiced bravado make for convenient political theater but don’t truly influence national security, however the race to dominate the future of these tech industries does and gets to the heart of the American conundrum that is China. Of interest is the issue of U.S. intellectual property and the gambit to cut China off from access to critical U.S. technologies, forcing China to accelerate its long-term plan to develop an indigenous, next-generation semiconductor industry.

Shutting Out the Dragon

While we remain working from home, we held several conversations with our Chinese acquaintances — a few of which focused specifically on emerging Chinese technology and semiconductor fabrication. Semis are the integrated circuits that make modern digital technologies possible. They are the world’s most complex technology and China’s leading import (in $US). The lack of indigenous, next-generation capabilities leaves China vulnerable to the gauntlet thrown down by U.S. sanctions, and is the nucleus around which all other Chinese technology investment revolves. The process of manufacturing, testing, and packaging the integrated circuits that power the modern world is extraordinarily complex and capital intensive. The industry itself is in transition as value and demand has shifted from general-purpose multi- function processors made for PCs, phones and servers, to processors designed specifically for artificial intelligence and machine-learning capabilities — the emerging technologies in which China has invested heavily and aspires to take the lead in.

What is a next-generation chip? Chips are identified according to the size of the manufacturing node and indicates the circuits’ generation and architecture. Expressed in nanometers, or nm, nodes are microscopic: one nm is one/billionth of a meter wide (a human hair is ~75,000 nm). The smaller the node, the smaller the resulting transistors, which enable faster processor speeds, increased energy efficiency and, of great relevance, entail extreme manufacturing complexity. At present, only two companies, one from South Korea and the other from Taiwan, are manufacturing semiconductors at volume in the most advanced process node (7nm), and are in an race to develop 5nm, and then 3nm (for which there are already pre-orders to meet designs planned for release in a few years!). China’s national champion currently has 14nm capability, a process node first achieved by the U.S. in 2011, and capable of powering technologies of that generation (e.g. the iPhone 3). But this dated technology was enabled by U.S. patents and it is unclear that China would be allowed to utilize the intellectual property going forward.

The technical and manufacturing challenges that will have to be overcome in order for China to be fully independent and self-reliant are immense and would require firms to recreate, from scratch, all the incredibly complex tools involved in producing chips. At the heart of this challenge is the fact that most of critical intellectual property is American. It begins with developing the electronic design automation (EDA) software, which acts as a virtual simulator for the physics of chip design. Then there is the hardware, the extraordinarily complex fabrication equipment including wafer processing, testing, assembly, and packaging. The critical process that even industry legend Intel has stumbled to successfully apply at scale at 7nm is the extreme ultraviolet lithography (EUV) used for the latest cutting-edge generation of production — described to us as “as close as the world has gotten to playing with pure chemistry and light”. Still, in setting the goals for its next five-year plan, China’s leadership declared that “self-reliance in science and technology is a strategic pillar of national development” and put a time horizon to lead in semiconductor manufacturing within a decade. That is a similar timeline they announced for the development of an indigenous Chinese aviation industry years ago and, while China is capable of flying a domestically built, wide-body passenger plane, they have yet to master the jet engine. Western companies spent decades, not years, perfecting each generation in engine and semi-fabrication technologies, and while China will be able to afford the exorbitant investment required, they will be moving forward without the American IP tool chest — a problem that cannot be overstated.

The competitive landscape and financial demands of advanced semiconductor manufacturing have changed considerably over the years, and the economics of semiconductor manufacturing in the single- digit-nanometer era requires the collaboration of a critical mass of industry leaders. For China, forced technological decoupling requires engineering a series of nontrivial technical breakthroughs and reinventing thousands of very complicated wheels. These technical challenges are not insurmountable and there are no theoretical barriers preventing their invention, however as one climbs this high on the value- added chain, the time required becomes exponential, and the margin of error shrinks dramatically.

Back to the Future

The U.S. can afford to take a hard stance on technology protection because of its broad IP ownership. However, when it comes to blocking China in virtually any other area — including convincing others to stand with its anti-China policies — only multi-lateral agreements and international agencies are up to the herculean task. As we described here four years ago, in its first of many contradictory foreign policies, the administration’s very first action was to walk away from the Trans-Pacific Partnership (TPP) — an agreement specifically designed to counter China’s rising power through strengthened trade agreements across the Indo-Pacific. Today, in nearly perfect bookend symmetry, fifteen Asian neighbors have ratified a trade deal of their own — the Regional Comprehensive Economic Partnership (RCEP) — with China at the center, and the U.S. on the outside looking in.

In choosing “America First” populism and snubbing its TPP allies, the U.S. gave up negotiating power with countries representing 40% of global GDP and the opportunity to collectively hold China to higher socio-economic standards. Instead, the President resorted to unilateral tariffs, even imposing them on allies using dubious legal justifications. And although the U.S. has not withdrawn from the World Trade Organization, the administration has tied it in knots by refusing to approve judges for the panel responsible for adjudicating trade disputes.

The relentless rise of China has been a secular theme for decades and, coming out of this pandemic chaos, has been fueled even further by the country’s ability to punch its way through Covid early. The RECEP trade deal is now the largest global trading bloc, covering a market of 2.2 billion people (30% of the worldwide population) and ~$26 trillion of economic output. The U.S. will likely remain China’s largest trading partner for quite some time, but this deal, when combined with being a top creditor nation, gives China an important source of support, and leverage, in the future as it fends off U.S. opposition.

Great Expectations

We typically end our communiques with a comment on how we internalize the themes shared with you in our large-cap equity strategy (LCES) portfolio structure. However, what has occurred since March’s market bottom requires its own, pre-conclusion observation. Ask investors why they are bullish for 2021 and they will tell you that they see a light at the end of the dark Covid tunnel. There may be many potholes — with cases, hospitalizations, and fatalities on a disturbing upward trajectory, and a very tough winter ahead — but there is a vaccine and with it, a light that we all can see. This fires the imagination for a post-pandemic spending boom — it’s only a matter of how large, how long, and when it begins. Much of this good news is already priced into every global financial asset you can possibly name so that even the beaten-up airline, casino, retail and hotel companies have rebounded due to this end-of-tunnel glow.

Vaccines notwithstanding, one would rationally think that a future with massive public deficits, soaring debts, monetary and fiscal intervention, and increased regulation would calm the enthusiasm for risk assets, but no, sentiment remains extremely bullish. As we have seen throughout this ordeal, the market can cope with bad news because the Fed has repeatedly told us they will do everything to prevent another adverse market outcome and, given the level of interest rates, the buying continues and the market advances nearly unperturbed. But the crux of the issue is why rates are so depressed and how can that possibly be consistent with the expected growth?

Ironically, the bullishness is based on the notion that that we are soon to return to a pre-Covid world, meaning a return to slow growth, low interest rates, and low inflation! Strategically then, this should mean more of the same: secular growth stocks (i.e. FAANGM: Facebook, Apple, Amazon, Netflix, Google, Microsoft) have the large addressable markets, earnings visibility, strong balance sheets, and don’t require government assistance. Cyclical value stocks are cheap, cheap, cheap — but have no earnings visibility and lack catalysts outside of the crutch of policy stimulus. For these to work requires faster economic growth, signs of inflation, and higher interest rates.

And, not surprisingly, this is exactly what market cheerleaders point to as all the stimulus is thought to have created the conditions for an economic acceleration. The proverbial fly in the ointment is that, pre- pandemic, the inflationary impact of a $1 trillion deficit, repeated quantitative easings, and more than a decade of suppressed interest rates produced very little inflation. To the low growth/inflation/interest rate list we should add the growing secular forces of aging demographics, massive debt burdens and extreme income and wealth inequality. While these are long-term structural issues, the requirement for higher interest rates is something that will be kept in check. A McKinsey analysis provides the rationale: a 1% rate increase will create an $800 billion surge in debt-service costs, adding significant additional liabilities with untold implications. Monetary stimulus and zero interest rates are a fact of life for now and will continue to drive asset prices and investor sentiment until the point when valuations become intolerably high, even in relation to record low interest rates.

A recent Bloomberg analysis of the 3,000 largest publicly traded companies reveals that 25% of the firms cannot cover their debt-service out of internally generated cash flows — so called zombie companies. Even more stark, these zombie firms added ~$1 trillion of debt to their balance sheets this year, bringing total obligations to ~$2 trillion (pre-pandemic zombie debt was $378 billion). We don’t mean to frown on the predicament this pandemic has foisted on the Fed and understand that tourism — entertainment, hotels, restaurant, airlines, and retail — are in financial distress and facing challenges unlikely to dissipate quickly. Pre-crisis, these service sectors supported 32 million jobs — 33% of the non-governmental workforce. The politics of fiscal policy are as appalling as ever and can never really fill the gap as it stands but, as we have pointed out in recent communiqués, the market is not the economy.

Economist David Rosenberg recently opined, “When you have central banks behaving like private money managers, and the discount rate converges on the risk-free rate at zero, the equity risk premium completely vanishes, and investors build a view that multiples can expand to infinity. Junk bonds can then trade like investment grade and investment grade trade like government-guaranteed Agency debt. That is our reality and forecasting is a fool’s errand in an environment of persistent uncertainties”.


The large companies will continue to get larger and enjoy a bigger piece of the pie while the economically sensitive firms will remain volatile and unable to provide guidance. This has created tremendous market bifurcation where just six companies account for most of the market’s annual return. This is extreme but history is replete with moments with a high concentration of returns. It won’t always be like this and investors yearning for a change in leadership should recognize that a year that sees Tesla with a higher value than the entirety of the global auto sector, and Airbnb with a greater value than the global hotel sector, does not represent a new normal. If you are rational in thought, into deep analysis, and as focused on risk and capital preservation as we are, this is not your market. But we can and do participate and continue to buy on the thematics: growth companies with utility-like characteristics, strong balance sheets and realistic earnings visibility (the up-market), combined with high cashflow growth, high dividend yield, GDP+ growth themes (the down-market).

From our families to yours, we wish you all peace and good health in the coming months.

Yours truly,

Hirschel B. Abelson

Adam S. Abelson
Chief Investment Officer

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© 2017 Stralem & Company Incorporated