There aren’t many times in business when no one wins, but it happens in trade disputes. To say that the U.S.-China trade negotiations are challenging is an understatement. A silver lining exists, however, as current tensions are likely to dissipate as China cooperates. While it may not seem evident this will happen, U.S. domestic leverage coupled with China’s incentives to yield will probably lead to a convergence of trade policies. The U.S. will ultimately force the creation of a more level playing field.
Unfortunately, in the short-term, everyone loses. This includes major Chinese smartphone manufacturers (for example, Huawei and Xiaomi), many U.S. chip suppliers (take Qualcomm and Intel), and of course consumers hurt by tariffs. Meanwhile, Apple has the most skin in the game, as the biggest tech company with real sales presence in China. Google will get hit indirectly, as its Android services get limited for Chinese manufacturers. Ultimately, it’s equal opportunity pain.
China faces a few very difficult realities that must be balanced in the trade talks. First, the Communist Party’s control means the country is effectively a surveillance state. Second, its protectionist ways have led to an implicit endorsement by the government of intellectual property theft. Third, the supply chain relationships companies have formed so far certainly aren’t permanent. In fact, the cost advantages presented by China are quickly diminishing relative to other emerging markets. And fourth, there is bipartisan support for actions against China, perhaps the one good example of that in this partisan world.
To understand the framework of the U.S.-China relationship, it may help to think about what we call “cooperation theory.” It explains why the trade relationship was successful until now, and why reconciliation is a more likely scenario. Think of cooperation theory as the coalescence of game theory and modern finance. In a nutshell, it explains how trust is the defining characteristic of all financial relationships.
Cooperation yields a virtuous cycle by allowing specialization, increased productivity, and a growing pool of resources available to all parties. The greater the trust in the system, the more players play the game, as each individual seeks to leverage his or her strengths. This process “scales” exponentially, augmenting wealth in a non-linear fashion. But things can unravel just as quickly, leading to a collapse of wealth faster than may have seemed possible.
Stock markets are complex systems that incorporate a multitude of factors, including valuation assumptions, future cash flow predictions, and importantly, the discount rate. Modern finance teaches us that the value of future cash flows, adjusted for today’s dollars via the discount rate, is what an asset is worth. The thing about the discount rate is that it incorporates a risk premium to adjust for investment uncertainties beyond that of a risk-free assets such as Treasury securities. In reality, the discount rate and any associated risk premium is nothing more than the level of trust in the investment, whether an individual stock, the stock market, or in this case, China’s trade relationship with the U.S.
Trust consists of three facets– trust that the terms of the game stay the same, that the rules stay the same, and that people or entities involved will play for a long time. When the rules of the game change, so does the trust factor, and in turn, value. Mutual trust has served as the current in the river of time; market stability (lower discount rate) was the byproduct of that trust, while volatility (higher discount rate) arises when trust disappears.
Chinese manufacturers rely heavily on U.S. technology. Losing access will significantly hinder their ability to keep up. It’s no secret China controls a bulk of the elements necessary to produce chips based on today’s technology. It’s important to remember that old technology always competes against new, and today’s required resources won’t necessarily be tomorrow’s.
If you’ve ever studied game theory, you may have come across a game called Prisoner’s Dilemma. It posits that if two criminal partners are faced with charges, the best case scenario for both is if they cooperate– if they cheat, you cheat; if they cooperate, you should cooperate. This strategy of cooperative results in everyone spending the least amount of time in jail over the long term. A mixed outcome, however, maximizes sentencing for the “un-cooperator.”
China can prolong the fight and try to go after Apple, or hurt U.S. chip manufacturers. Or it can try to force Trump’s hand on tariffs and hurt domestic consumers. China could also try to cut off most ties with the U.S. and build its own Silicon Valley. The problem with not positively cooperating (or retaliating) is that the relative pains will be greater for China, because this will devolve into a race of adaptability. Here’s the bottom line: China’s best choice is to cooperate.