News In Charts: Equity investors are not worried about a US/China trade war

Tensions between the US and China appear to be rising, with disagreements over North Korea and the possibility that Donald Trump will invoke national security concerns to slap tariffs on Chinese steel imports. But if the chances of a trade war have increased, equity investors remain unconcerned. In fact, our China Exposure Index (CEI) shows that US firms with exposure to China continue to outperform their rivals. We have revisited the way we construct our CEI; building on our existing methodology we have constructed two new CEIs – a broad one, containing firms of all sizes, and a narrow one, containing only large firms. In this note we look at these CEIs and discuss our findings.

To recap, Fathom’s CEI is a gauge of the relative share price performance of US-listed firms with revenue exposure to China. The CEI is constructed using a selection of US-listed corporations that derive more than 15% of their revenues from China. The index is not weighted by company size; rather, the weight of each corporation in the index is proportional to the share of its revenues derived in China. The index reflects the price movements of each corporation relative to its appropriate S&P 500 sector benchmark and should, therefore, be seen as a measure of relative performance. Our original CEI has outperformed its benchmark by around 15% since Donald Trump won the US presidential election on 8 November 2016.

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Using broadly the same methodology described above, we have created two new CEIs: a narrow CEI and a broad CEI, which we henceforth call CEI 2.0 (narrow) and CEI 2.0 (broad). CEI 2.0 (narrow) is similar to CEI 1.0. Each has followed a similar path since inception, as shown in the chart below.

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The broad index, CEI 2.0 (broad), is made up of a much larger number of firms than the narrow index, CEI 2.0 (narrow). In addition, the broad index includes medium- and small-sized firms, while the narrow index contains only large firms.

The narrow CEI and broad CEI have outperformed their benchmarks since inception. Both indices rose strongly in the first two months after Donald Trump’s election win. Since then, however, the narrow CEI has continued to rise, while the broad CEI has trended sideways. This tells us that among US firms that derive a significant share of their revenue from China, larger firms have fared better than smaller firms since January. One possible explanation is that investors expect Donald Trump to negotiate better access to the Chinese market for larger US firms than he will for smaller US firms. However, it is also possible that investors have become less optimistic about Donald Trump’s ability to negotiate better access to the Chinese market for US firms more generally, given the sideways trend of the broad index over the last five months.

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That being said, there are at least three reasons why US-listed firms that derive a significant share of their revenue from China have fared better than their peers since 8 November.

First, earnings growth of some firms in our CEI has been very strong, which, in some cases is a direct consequence of exposure to China. Indeed, with Chinese policymakers still ‘doubling down’ and economic growth in China accelerating even quicker than we previously thought, it is unsurprising that the earnings of firms with exposure to China are growing quickly.

Second, in order to rebalance the US/China trade relationship, we think that China is prepared to give better access to its market to US firms than it currently does; and firms that already have a presence in China stand to benefit most. We have previously compared the US/China trade relationship to a game of chicken and in this game, the US holds all of the cards. Indeed, following the meeting between Donald Trump and Chinese President Xi Jinping earlier this year, China granted better access to its market for US ratings agencies and US meatpackers. There is further scope for it to open up its market to US corporations, especially technology firms and financial institutions.

Third, the recent appreciation of the renminbi will boost the earnings in US dollar terms of revenue earned in China. As the next chart shows, with the exception of the first few months after Donald Trump’s election win, both CEI 2.0 (narrow) and CEI 2.0 (broad) exhibit correlation with the USDRMB exchange rate.

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We would not be surprised if our three CEIs continue to rise. After all, we expect two of the three forces that appear to have driven it higher in recent months to continue: China’s economy will continue to grow strongly; and Chinese policymakers will continue to allow greater access to their markets to US firms than they currently do. Admittedly, the recent appreciation of the renminbi is likely to be unwound in the coming months, which would make earnings derived in China less valuable in US dollar terms than they would be with the USDRMB at current levels. But the potential for earnings growth is likely to more than offset the headwind from a weaker USDRMB exchange rate.

The bigger picture is that, despite some seemingly inflammatory rhetoric from Mr Trump, investors appear unconcerned about the prospect of a trade war between the two countries. After all, disagreements and tensions between the US and China are nothing new – the difference now is that Donald Trump is a lot more vocal about these differences than his predecessors were. It remains to be seen whether he will succeed in significantly changing the US/China trade relationship. A trade war cannot definitely be ruled out, but the chances of one occurring anytime soon appear very slim. Of that point, equity investors are convinced.

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