US-China war in 2025

Public predictions of a US-China War in 2025, made this week by US General Mike Minihan, head of Air Mobility Command, and Mike McCaul, chairman of the Foreign Affairs Committee in the House of Representatives, might raise considerable alarm for anyone already highly sensitised by global geopolitical risk. This follows the establishment of a new US congressional select committee focused on strategic competition with China.

"My guts tell me we will fight in 2025", wrote Minihan in a memo to Air Mobility Command. "I think he is right", responded McCaul in a TV interview.

As recently as 11 January, Secretary of Defense Lloyd J. Austin, said, “we believe that [the Chinese] endeavor to establish a new normal, but whether or not that means that an invasion is imminent, I seriously doubt that". And an anonymous Pentagon official commented that Minihan's words were "not representative of the department's view on China".

Opposition to and suspicion of China is one of the only issues on which there is bipartisan consensus in the US Congress. That does not preclude politicians from both the Republicans and Democrats seeking to outdo each other in terms of burnishing their anti-China credentials.

While the policy of strategic competition with China is not going away any time soon and is becoming increasingly institutionalised, investors should distinguish substantive changes in policy that affect risk and valuation – eg recent restrictions on advanced semiconductor and technology sales – from rhetoric and posturing – the comments this week from one US general and one senior Republican likely fit into this bracket.

China – Why would China engage in a war, eg around Taiwan, that it cannot easily win, given ongoing US naval superiority, a re-galvanised NATO coalition and a re-arming Japan? How can China afford such a war when its economy is no longer growing at the pace it used to?
The US – Why would the US provoke a war that will destabilise its supply chain for most of its consumer goods and trigger a major escalation in global inflation? Is a more secure Taiwan and a merely weakened Chinese military (given a conquest of China is out of the question) worth it?

The answers to these questions suggest that remarks made by Minihan and McCaul may be driven, at most, by a desire to signal US military resolve, and, at least, by an effort to motivate rank and file military, secure support for funding the Asia-Pacific military presence and domestic political point scoring.

I have been wrong before on predicting war – buried many, many reports ago was my doomed 22 February 2022 prediction that Russian President Putin's most rational course of action was to secure Donetsk and Luhansk and venture no further, although the scepticism I have voiced on hot conflict escalation, after different flashpoints, on Israel-GCC and Iran, or India and Pakistan, has been more appropriate.

What has not altered this week is the enduring tension between the US and China. This will set the backdrop for all emerging markets over the next decade. I review the global EM investment considerations of this below.

Military match-ups across global hotspots

Competing geopolitical agendas

The US seeks cooperation (climate), competition (trade and investment) and no compromise (access to advanced technology, Russia, Taiwan) with China, and pitches a mix of defence security cover (Asia is where the majority of overseas US military personnel are located) and inward investment to others, particularly the ASEAN countries.

China has the desire to restore more cooperative relations and maintain its independent stance on global geopolitical issues such as Russia-Ukraine and Taiwan, as well as pitch the benefits of greater trade and investment integration (largely under the umbrella of RCEP but with some potential, post-Covid, revival in Belt and Road too) with all others, particularly the ASEAN countries, with no hint of softening its territorial claims in the South China Sea (the 'nine-dash line').

All others from India, to ASEAN, the Middle East, LatAm and Africa, will attempt to tip-toe the increasingly narrow neutral space between the US and China, in the knowledge that China is now their main trade and investment partner but that the US provides their most credible guarantee of defence against Chinese territorial incursion.

Implications for investors

Tech in Japan, Korea, Netherlands, and Taiwan (TSMC)

Semiconductor, semiconductor equipment and testing, and Tech hardware component suppliers are all facing restrictions on their sales of advanced products to China.

The most concentrated exposure for EM investors is in Taiwan Semiconductor Manufacturing Company (TSMC).

TSMC is the largest single stock in the MSCI EM index and has a 5.7% weight. Taiwan, overall, has a 13.8% weight, third behind China-HK (34.2%) and India (14.4%).
China accounted for 12% of TSMC revenues in Q3 22 and has averaged 11% over the past year and 15% over the past five years.
Global sales of advanced products, 7nm and 5nm chips, accounted for 53% of global TSMC revenues in Q4 22 and have tripled in absolute value since the start of 2020. They represent the next phase of growth. Older generation 16nm chips, which also may be snared by US restrictions, accounted for 13%.

Any spike in China-Taiwan-US friction would compound existing global growth concerns. With forward 12-month PE of 15.7x, a 12% discount to the five-year median, some risk of a hotter conflict with China is priced in, but a great deal less compared with a few months ago, when this multiple troughed at 9.6x.

China share of TSMC quarterly global revenues

TSMC PE valuation is at 12% discount to 5-year median

Manufacturing in Asia (Vietnam) and Mexico

The 'China +1 manufacturing' strategy shift by US and EU multinationals, in search of greater supply security, lower wage cost and lower tariffs, should benefit the likes of Vietnam in Asia and Mexico in LatAm.

This is not a straightforward transition, particularly in Asia, because of the deep integration of most Asian manufacturers with supply chain intermediary inputs from China (eg Chinese imports equate to around one-third of Vietnam's GDP) and existing trade relations with China (RCEP, where the likes of Indonesia, Japan, South Korea, Malaysia, the Philippines, Thailand and Vietnam are members).

Vietnam is our top pick globally on the theme of 'China + 1': its equities are cheap relative to history, it boasts manufacturing export growth driven by political stability and free trade agreements with the US and EU, domestic consumption growth driven by job creation and urbanisation, and the adoption of leap-frogging technology.

Its risks remain the onset of population ageing at an income level below those of Asian peers and the lack of transparency in policy-making and transition of power within the Communist Party.

Clearly, near-shoring of manufacturing should be a positive long-term driver of Mexico's investment case but valuation is at a small premium to the historical average and the risks of security disruption from the intensifying drug cartel war are material.

"China + 1" beneficiaries: Mexico wages lower than China, albeit high versus other EMs, but very low tariffs (USMCA) and transport costs to US

"China + 1" manufacturing in EM: relatively cheap wages and equities in Vietnam (more so than in Mexico)

Africa, LatAm and the Middle East

Commodity exporters in Africa, LatAm and the Middle East are exposed to US-China friction in four ways:

Commodity demand growth is led by China (as well as others in Asia, particularly India) and, for some time, this has drived a re-orientation of relations eastwards;
China is an important source of inward FDI usually without the governance conditions attached to funding from the US (or EU);
Commodity prices tend to spike in periods of elevated global geopolitical tension; and
Commodity exporters with large external account surpluses are increasingly venturing into transacting with China (and others, eg India) in non-US dollar currencies (albeit this will remain a marginal process, with the US dollar remaining the dominant global reserve currency for the foreseeable future).

These commodity exporters tend to be less directly exposed to US-China relations, compared with other parts of the EM universe discussed above, and this is likely to remain the case as long as the sort of sanctions on sales of advanced Tech are not applied to basic commodities.

But this does not make their attempt to navigate a middle road between the two any easier.

Eastern Europe

US-China relations have a bearing on the progress of the Russia-Ukraine War. To the degree that China finds Russia a less reliable partner and finds it expedient to signal less overt support for Russia, as a way of softening relations with the US and the EU, Russia becomes more isolated.

Russia's territorial setbacks and the extensive armament of Ukraine, which have put paid to any prospects of a quick conquest, China's publicly voiced concerns voiced over nuclear weapons threat, and German Chancellor Scholz's trip to China to reinvigorate trade ties, and General Secretary Xi Jinping's pragmatic policy turn, including softer rhetoric on foreign policy, are consistent with this thesis.

Hungary, with the highest share among emerging EU peers of primary energy supply from Russia, is the most exposed to Russia-Ukraine de-escalation or freeze and has a cheaper equity market relative to the historical average than others in Russia's periphery, like Georgia, Kazakhstan and Poland. It has already leveraged its effective veto on EU sanctions on Russia and on EU minimum tax rules to unlock access to EU Recovery Funds.

Hungary PE at a 60% discount to 5-year median

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