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Relations between the United States and China have further deteriorated since the beginning of May. Although the structural, multiyear conflict had briefly paused when both countries signed a “phase one” trade agreement in January, tensions escalated again recently with a number of significant actions from both sides (Figure 1).
We believe these events indicate an unsurprising reacceleration of this conflict. Evidence can also be seen in the rising tensions in the South China Sea, as well as in the recent military conflict between China and India, a US ally. In the near term, US-China relations are likely to remain under particular stress as November’s US presidential election approaches and the COVID-19 pandemic continues.
The potential impact of US legislation
“The Holding Foreign Companies Accountable Act” is one of roughly 270 proposals in the US Congress targeting China, many of which touch on capital markets and investing. The proposed law would bar any foreign company from listing on US securities exchanges if it has failed to pass the US Public Company Accounting Oversight Board’s (PCAOB’s) audits for three straight years. This development is neither unprecedented nor unexpected as the inconsistencies between the US Securities and Exchange Commission (SEC)/PCAOB rules and Chinese national security legislation have long been discussed.
The bill, which was approved in the US Senate, will now need to be passed in the House of Representatives and be signed by the president in order to become law. In its current form, the law would not cause Chinese companies in the US to be delisted automatically. Instead, as noted, companies would need to fail three consecutive years of audits and be deemed subject to removal by the SEC.
If the law is passed as written, we think its direct and immediate impact on equity markets may be limited. After all, the bill’s design offers years for Chinese companies to adapt to the new US standard. And even if Chinese ADRs were to ultimately delist, Chinese domestic capital markets are supported by deep local savings pools. Importantly, this proposed law would also not stop existing US investors from trading ADR ownership for locally listed ownership, as it does not prevent US-based investors from purchasing the equity of Chinese businesses listed in Asia.
In addition, a comparison of two major Chinese conglomerates — one with a US listing and one without — shows that the firm with an ADR listing does not receive a valuation premium for its access to US capital markets. This could indicate that at least large companies may be able move away from ADR listings through new listings on exchanges such as Shanghai or Hong Kong without harming their market capitalizations. However, the law may prove challenging for smaller Chinese companies that are only listed in the United States.
New Hong Kong security laws
Notably, the US was not alone in announcing new legislation. China opened its annual National People’s Congress meeting in May by revealing new laws that seek to prevent, stop, and punish secession, subversion, foreign interference, and terrorism in Hong Kong. The decision sidestepped Hong Kong’s legislature and has called into question the “one country, two systems” model which has been in place since Hong Kong was turned over by the British. In response, President Trump announced that the US would terminate Hong Kong’s special trading status — which would allow the possibility of US sanctions. Since the law took effect at the end of June, the US has enacted several policies that further distance the two countries and prompted tit-for-tat responses from Beijing.
While the US-China conflict has been shaped by the Trump administration’s policy, increasingly negative perceptions of China in the US have yielded bipartisan support for tough policies (Figure 2). We therefore believe tensions are unlikely to end regardless of the outcome of November’s US presidential election. In fact, we think the conflict will continue to escalate as rhetoric accelerates approaching the election. However, we are also mindful of the deep economic and financial ties that continue to bind the world’s two largest economies together. Within the confines of economically rational decision making, we think these ties will draw boundaries around negotiations.
We find it helpful to consider US-Russia relations as an example of where we may ultimately see the limits of this conflict. In 2018, various Russian sanction proposals were put forward, but most were not implemented. This was, in part, due to their inevitable impact on other economies and financial markets. For instance, we think the US Treasury Department understood that forced sales of foreign-owned Russian assets would negatively impact US institutions and individuals, as well as our allies.
Finally, we know from experience that disruption creates winners and losers. Select companies in and around China continue to benefit from a multiyear import substitution trend, driven by the trade dispute. In addition, the COVID-19 crisis is likely to further accelerate the evolution of global supply chains. While this may eventually harm some Chinese exporters, such as health care equipment manufacturers, at the same time, we expect many consumer and technology companies to see increased demand as Chinese buyers shift to shopping locally.
As US-China tensions intensify amid COVID-19, the US election, and many legislative proposals, we’ll continue to offer our latest insights on how the evolving conflict could impact global investment markets.