The Coming Storm: Likely Fallout from China’s Focus on Strategic Industries

Overview‍

A planned economy is unlike others in that normal checks and balances are removed. To maintain GDP and employment targets, China is reinvesting its impressive trade surplus (near $1 trillion per annum) in industries it views as strategic with massive implications.

For sophisticated institutional investors and risk managers, this theme is likely to have a major impact on portfolio holdings over the next couple of years and beyond.

‍False Assumptions‍

The traditional view of business is that competitors have constraints, which drive outcomes. For example, a certain level of investment is typically required to set up and establish a business. Another is that, over time, the business needs to make a profit. Lastly, and most importantly, businesses typically do not sell products for less than their marginal cost of production.

Unfortunately, for numerous  industries, those “assumptions” are proving to be false as in China, the state appears to be willing to forego these basic assumptions in an effort to stoke GDP and maintain employment. While claims of unfair practices are multiplying, those claims take time to address and, in the meantime, industries are hollowed out.‍

Figure I: China Trade Surplus in Goods (Rolling 12 months, $ Billions) (source)

Historical Perspective

The partnership between government and commerce is nothing new. The Dutch East India Company, the South Sea Company, the British East India Company, Hudson’s Bay Company and numerous others were granted special concessions and monopolies on various trade areas. However, two distinctions are relevant: one is that such arrangements are rare in modern times, and two, the extent of government support was minimal post the granting of the charters. Per the Economist, “European firms have long complained that their Chinese rivals benefit from artificially cheap land, energy, capital and other subsidies.”

Disturbing Patterns

An axiom in the technology area is that it is often not the developer of the technology that reaps the benefits, but rather the user. Extending this axiom to the matter before us, our view is that it is not the developer of the new technology, but rather the firm that is able to make products based on the technology. The depressing thought is that much of the design and technology work for some of the newer industries was done in the West (particularly in America), and that the benefits of manufacturing the new items are often realized in China. Perhaps the ultimate example is that an automobile probably contains $500 of raw material (e.g., steel, plastics, rubber, coatings, etc.), which, after conversion, can be sold for $50K. Per Elon Musk, manufacturing is far harder than design.

Focus Areas

Now for the relevant part for most readers and that is which industries are likely to be impacted and the extent of the possible damage. Below is a partial list and our ranking of relative risk to the existing firms:

• Aerospace (low for SpaceX) - with the militarization of the economy and the critical importance of airpower and soon space power, China is likely to view this area of high strategic importance. It is unlikely China will deem it acceptable that SpaceX is responsible for over 90% of all of Earth’s payload mass to orbit. Below is a quote from Everett Dolman, professor at the US Air Force War College:

“The measure of great power is calculated in arms and industry, and space is so integral that unless there is a massive change in the current trajectory of global interaction, any future war between major powers will be won or lost in the battlefield of space.” (airuniversity.af.edu)

Figure II: Spacecraft Upmass Carried by Launch Provider (Q1 2024) (source)

• Airplane Manufacturing (moderate for Boeing and Airbus) - post Russia’s attack on Ukraine, Russia was frozen out of purchases and parts for its domestic air fleet. (Of course, there is that disturbing fact that Russia refused to pay for or return leased aircraft). Hence, China will continue to invest in domestic production. Comac is generally considered a weak competitor but is likely to be upgraded over time.

• Artificial Intelligence (uncertain) - given the strategic importance of this industry, it is hard to envision this NOT being a focus area. DeepSeek garnered much publicity, but there are many other contenders. Three of the top text models were created in China. Only one of the top vision models is American. It may be the case that a competitive moat is difficult to establish in the AI race due to models being trained on similar public data. This has been shown by the regular rearrangement of the AI leaderboards.‍

Figure III: Artificial Analysis Intelligence Index (Q1 2024) (source)

Figure IV: Artificial Analysis Image Arena Quality ELO (source)

• Automobiles (extremely high for most legacy firms) - within the past couple of years, China’s brands have become world-beaters particularly in electric vehicles. Assuming the costs of batteries will continue to decline, and that China can easily offer more internal combustion engines, even with tariffs, legacy manufacturers are vulnerable. BYD, Chery, Geely, and SAIC is among the leaders.

‍Figure V: Global EV market share of the top five EV sellers plus the Detroit 3 (source)

• Chemicals (moderate to high, especially if China can obtain high volumes of low-priced Russian energy and inputs) - while the country does not have an apparent advantage currently, given the support China has given Russia over the past four years for the Ukraine war, China is likely to have favorable supply contracts for the foreseeable future.

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Figure VI: Average capacity utilization in German chemical plants (source)

• Computer Chips/ Computers (high over time) - again, given the strategic importance of this area, China has been, and will continue to, focus on the area. The rapid development of Huawei’s smartphone chip indicates that rapid advances are possible despite blocks and Lenovo has long been a PC leader.
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• Mobile devices (high) - while Apple and Samsung have been historic leaders, watch for the domestic brands (particularly Xiaomi, BBK, and Huawei) to continue their growth.
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• E-Commerce and Media Platforms (moderate) - given the focus on state security, China is unlikely to let any non-local firm to dominate this area and will seek to export influence. Alibaba, Tencent, Baidu, and JD.com are likely to remain dominant.
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• Fusion Energy (moderate) - this will be a focus area to reduce China’s dependence on imported energy.
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• Pharmaceuticals (moderate because of regulatory barriers) - the margins for winners in this area remain impressive. According to The Economist, “Almost half of German [pharmaceutical] manufacturers rely on products from China, according to the Bundesbank.”
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• Quantum Computing (high) - it appears that in coming years, the technology will become established.
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• Ship Building (high) - China views this area as critical if they are to realize continued access to trade.
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• Software (moderate) - while Microsoft, AWS, Oracle and others have long been leaders, China is building respectable offerings with Tencent and Baidu.

Offsets

The global trading system is out of kilter, with China maintaining massive trade surpluses and other countries (the US, UK, and to an increasing extent, the EU) massive trade deficits. The counterbalance is typically shifts in currency levels and tariffs. While some of that is occurring, it is not happening at the expected rates. We expect that discussions regarding corrective actions will take place over the next couple of years but that finding workable solutions will prove difficult.

Conclusions

We focused on this topic because it is a paradigm change: that is, the state is willing to make massive investments and incur losses to establish a presence in key industries.

Given enough money and resources, any business can be built. China is directing massive resources in a variety of industries with the likely result being pain for those with exposures to those industries. Particularly troublesome is the willingness to sell below marginal cost.

The above reminds us of the adage of John Maynard Keynes:

“The market can remain irrational longer than you can remain solvent.”

We hope and expect this installment is helpful to sophisticated institutional investors and risk managers in navigating the ever-changing investment landscape.