Can Markets Rise Above U.S.-China Tensions?

MIKE TOWNSEND: When I was growing up, there was a song that became one of those 1980s hits that you couldn't escape for a time―it was an earworm called "99 Red Balloons." It was one of those songs by an artist unknown in America that caught on in the early days of MTV. It rose to number two on the U.S. charts―I actually looked that up.

The song is enjoying another moment in the sun in 2023. That's because the song is about a boy and a girl who release a bunch of red balloons and watch them float away into the sky. But the balloons are picked up by both U.S. and Russian radar as unidentified objects, triggering defense warnings. Both militaries overreact and go on full alert, scrambling planes to shoot down what is perceived as a nuclear attack. All nations get involved, and suddenly everyone wants a destructive war. At the end of the day, nothing is left. Pretty grim stuff for a 1980s tune.

Well, while war is clearly not in our immediate future, the military shooting down balloons has suddenly become a real thing here in 2023. The Chinese spy balloon that floated across the United States before being shot down over the Atlantic Ocean earlier this month has been followed by the U.S. military shooting down three more floating objects. The sense is that those objects were not part of another government spying on the U.S.

But the Chinese balloon saga has led to increased tensions with the United States just as China is re-emerging on the global stage from its lengthy COVID hibernation. Those tensions are complicating the considerations for investors looking for opportunities in China and other international markets.

So what is an investor to make of the U.S.-China relationship, and how might it impact the markets?

Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.

On today's episode, I want to take a closer look at the state of U.S.-China relations and how rising tensions could impact investors, but also take a broader look at how investors should think about geopolitical factors when evaluating the risks and rewards of investing opportunities overseas. Joining me in just a few minutes to provide his perspective will be Jeff Kleintop, Schwab's chief global investment strategist.

But first, a couple of quick updates on some of the issues that are percolating here in Washington.

First, President Biden last week announced a high-level change to his economic policy team, naming current Federal Reserve Vice Chair Lael Brainard to be his top economic advisor and head of the National Economic Council. She'll replace Brian Deese, who announced earlier this month that he would be leaving the White House post.

Brainard, who has served as a Fed governor since 2014 and as vice chair since 2021, is widely seen as a possible successor to Treasury Secretary Janet Yellen if President Biden wins re-election next year. Brainard will immediately be thrust into a key role as the administration wrestles with tamping down inflation and the looming debt ceiling battle.

But it also means that there will be a vacancy at the Fed that the president has to fill―and that has triggered a frantic round of Washington's favorite pastime: speculating about who might be nominated for a top government position.

There are two ways the president could go here. One is to elevate a current Fed governor to the vice chair post and then nominate someone else to fill that seat. Lisa Cook, who is the first Black woman ever to serve as a Fed governor, is a possible candidate to be moved up to the vice chair slot. This would require two confirmation votes in the Senate, one for the vice chair and one to fill the open governor position.

The other option is just to nominate someone as vice chair, which would entail just one confirmation process. Attention has focused on three current heads of Fed regional banks: Susan M. Collins, who is president of the Boston Fed; Lorie Logan, who is head of the Dallas Fed; and Austan Goolsbee, who served as President Obama's top economic advisor and now heads the Federal Reserve Bank of Chicago. But there are other names that have also circulated if the president is looking for an economist not currently serving at the Fed.

Given the critical role the Fed is playing right now in raising interest rates to combat inflation, this will be a key nomination for the president and a closely watched confirmation process in the Senate.

Next, a quick update on the debt ceiling. Last week, the non-partisan Congressional Budget Office, known in Washington as the CBO, released its analysis of the situation and said that the extraordinary measures currently being taken by Treasury to ensure the United States does not default will run out sometime between July and September. Now that's not particularly helpful, as everyone already had their eyes on early summer as the potential default date. But the CBO also said that its analysis had a lot of wiggle room in it because of uncertainty around April's tax receipts. A strong season of tax revenue could push out the default date toward the fall, but weaker tax receipts could mean that the date comes more quickly, potentially even in late June.

I expect we'll continue to hear this kind of squishy language about the debt ceiling deadline for the next couple of months. But by late April, after tax receipts have been counted, we can expect Treasury Secretary Yellen to provide a much more specific timeline―and that's when the pressure on Congress will really ratchet up.

Finally, the SEC made some news last week when it agreed to finalize a rule requiring stock trades to be settled the day after a trade is executed. This is the next step in an evolution in recent years to reduce the time between a stock trade and final settlement of that trade. Back in the 1980s and early 1990s, it took five days for a trade to be settled. Then in 1993, it was reduced to three days after the trade date, where it stayed for more than two decades before dropping to two days in 2017. Now, with the SEC's latest move, beginning in May of 2024, that period will shorten to one day. That aligns the stock market with the standard that's already in place for trades of Treasury bills.

The move to what is known as "T+1" settlement grew out of the meme stock frenzy of early 2020, when stocks like GameStop Corporation went on these crazy roller-coaster rides, with their prices skyrocketing amidst huge volumes of trading by retail investors. That volume put pressure on the systems for settling trades. In a 2021 report that examined the meme stock frenzy and its impact on the broader markets, SEC staff recommended shortening the cycle to improve market operations.

At last week's SEC meeting where the commissioners formally adopted the proposed change, Chair Gary Gensler said that the change "will make our market plumbing more resilient, timely, orderly, and efficient."

Here's what it means for investors. Today, when you sell shares of a stock you own, you'll see the proceeds from that trade in your account almost immediately. But that's only a paper accounting of the trade. That money isn't officially yours until two days after the trade, when the settlement process is completed. The bottom line: shortening that process to one day means you get your money faster.

Operationally, it's a big change for market participants, hence the 14-month lead time, but once it kicks in next year, investors should benefit from the quicker resolution of trades.

On my Deeper Dive today, I want to turn our attention to international investing, with a particular focus on the U.S.-China relationship and what it means for the global economy and the global markets. I'm pleased to welcome back to the podcast Jeff Kleintop, Schwab's chief global investment strategist.

MIKE: Jeff, thanks so much for joining me today.

JEFF: It's great to be here, Mike.

MIKE: Well Jeff, there's a lot going on around the world, but there's no question that China is front and center for the White House, for the economy, for the markets, both here and abroad. And, incredibly, the thing that is top of mind right now is balloons. Now, I'm smiling while I say that, but this is pretty serious stuff. The United States shot down one confirmed Chinese spy balloon and suddenly we're shooting down other objects in the sky that may or may not be Chinese. It's kind of a crazy story, but it's had real implications in Washington, including the cancellation of Secretary of State Blinken's planned trip to China. So what do you make of all this, and how is it impacting U.S.-China relations?

JEFF: Well, the purpose of Secretary of State Blinken's trip was to establish a floor in deteriorating U.S.-China relations. And this squabbling on the sides of the Munich Security Conference this past weekend really only seemed to make prospects of a rescheduled trip ahead of China's National People's Congress, which starts on March 5, seem even more remote. And while Biden said last week that he would speak with President Xi to defuse tensions, there was no indication of when that might happen. The renewed tensions seem like unwelcome news for Beijing. China's focus for 2023 is on domestic economic recovery, not really wanting to be distracted by international relations. And Washington would like China's help in exerting influence to curb North Korean missile launches. So both sides seem to want to cool things down.

I think the main takeaway from all the hot air over the balloon is that it will likely make it harder for the U.S. and China to manage potential flashpoints in the relationship in the coming weeks and months that might impact financial markets. You know, a big one is the U.S. administration's forthcoming executive order on investment in China, which could have some pretty broad-reaching implications.

MIKE: Yeah, Jeff, this new executive order is expected to be a follow-on to the order from last fall that put restrictions on what semiconductor technology and equipment can be shared with China. So what's the focus of this order, and how will it reach the intended goal of putting some more curbs on China?

JEFF: From what I've gathered, it appears that the executive order will focus more on things like quantum computing and artificial intelligence and semiconductors but not include things like biotechnology or battery technology. Russia's war in Ukraine and China's more aggressive behavior has led to a new bipartisan consensus that the U.S. should do more to choke off China's military and technological growth. The Biden administration has taken several explicit steps to check Chinese ambitions in AI and quantum computing, with the clear aim of slowing the development of China's military capabilities. Last October, as you mentioned, President Biden imposed expansive restrictions on the kind of semiconductor technology and equipment that can be shared with China.

This upcoming, outbound executive order focuses on the government's desire for more information on U.S. investment in Chinese tech startups. It was a report, just three or four days ago, by a Georgetown University think tank, and it showed that U.S. private equity and venture capital investors, including the investment units of chipmakers like Intel and Qualcomm, accounted for nearly one-fifth of investments in Chinese AI companies from 2015 to 2021. And venture capital investments can provide intangible benefits beyond just money. That would include mentorship and coaching, name recognition, and some networking opportunities, and as such, Washington feels that U.S. investment in Chinese technology, particularly AI, merits additional attention and tracking. So this order would establish a new regime in Treasury to monitor U.S. investment in sectors of critical technology in China, a potential start towards restricting such activity in the future along the lines of that semiconductor order. That order, which put controls on advanced semiconductor tech, may present a challenge to the strategies of Chinese chipmakers. The threshold that was allowed under those controls still allows U.S. chipmakers to sell chips that are sufficient for a lot of current commercial applications. But, over the long term, the controls may hurt China's competitiveness in areas like AI, as these new hot language models like ChatGPT, they require a lot of computing power. And it would be very difficult for China to catch up domestically. But it's not clear if U.S. allies like Japan and Europe will join the U.S. restrictions. In fact, Japan made it pretty clear that they are not happy with U.S.'s unilateral approach on semiconductors and including memory chips and a few other things. And if they don't go along with it, China can get the technology it needs elsewhere, with the main impact of the control just felt in the loss of sales by U.S. chipmakers and semiconductor equipment manufacturers. So we'll definitely be applying a very close watch to how this executive order shapes up.

MIKE: I think here in Washington, Jeff, you know this focus on getting tougher on China from the administration is actually being welcomed on Capitol Hill by both parties. And that's a trend that's been continuing over recent months, as, I think, both parties want to crack down on China. During the last Congress, there was strong bipartisan support for the China competition bill, which boosted U.S. semiconductor manufacturers. And just a few weeks ago, in January, there was overwhelming support for the creation of a new House Select Committee on China to oversee some of the U.S.-China relation issues.

As part of this show of strength from Capitol Hill, we recently learned that new House Speaker Kevin McCarthy and some other Republicans plan to make a visit to Taiwan later this year. Back in August of last year, then-Speaker Nancy Pelosi traveled to Taiwan. And when she was there, she left no doubt about what she was doing. She said, "The visit should be seen as an unequivocal statement that America stands with Taiwan, our democratic partner, as it defends itself and its freedom." That trip sparked tensions between the U.S. and China. China conducted military maneuvers, sending ships and planes around and across Taiwan.

Do you think Speaker McCarthy's trip, if it happens, would generate the same type of response as Pelosi's trip, and just further heighten tensions between the two nations?

JEFF: This is another important potential flashpoint, and it's unlikely that a visit would go without a response. And it wasn't just Speaker Pelosi's visit that prompted action last year. You'll remember that in May, it was a bipartisan delegation led by Senator Duckworth that visited Taiwan on a previously unannounced visit, and in response, 30 Chinese warplanes made incursions into Taiwan's defense identification zone. And again back in April of last year, there was a bipartisan congressional delegation led by senator Lindsey Graham that arrived in Taiwan for a one-day surprise visit, and China's military staged exercises as a warning. And also, it isn't just the U.S. In December of last year, China dispatched a record number of bombers into Taiwan's airspace as part of a drill in reaction to a visit to Taiwan by the head of Japan's Liberal Democratic Party. So China likely will do something to remind Taiwan of the risk of a move to independence. But will they take it further than the planes and ships and live ammunition drills that greeted Speaker Pelosi? I'm not sure of that, given the longer-term incentives to cool tensions. The scale of the response, though, may be a sign of how willing China is to avoid furth escalation. So it's something we'll be tracking closely.

MIKE: Well, obviously, one of the other major global situations going on is the ongoing Russia-Ukraine war. With the one-year anniversary of Russia's invasion coming up later this week, it's clear that we've been in the long slog phase for months now. Battles continue, gains are incremental, prospects for a resolution anytime soon look really bleak. Early on, the West imposed sanctions on Russian oil, setting price caps with the goal of restraining Russia's ability to finance the war. From the beginning, China has said that they would not abide by those price caps. And, as China reopens after COVID, they're buying even more Russian oil, essentially helping fund the Russian war effort. And now it appears they're taking it even further―selling Russia "non-lethal" military assistance along with economic support. So what kind of ramifications are likely from this violation of Western sanctions?

JEFF: Well, evidence suggests that China is benefitting from the price cap with Russian Ural grade crude bound for China trading at a 42% discount to non-Russian oil and below the price cap and trading at about $49 a barrel today. China has been careful to balance its interests to come out ahead. And that applies to the war itself. China has been careful to steer clear of direct military aid, yet still sell some goods to Russia. American officials say that China, unlike Iran and North Korea, has over the year of the war in Ukraine refrained from giving material aid to Russia. But a few recent press reports suggest there might be sales of gear like uniforms by Chinese companies. It's not clear if this support violates any sanctions or if the U.S. would impose new sanctions or costs on China for this non-lethal support, but it is clear the U.S. is sending a warning to China about starting any shipments of weapons or ammunition that would most likely lead to a further significant escalation.

MIKE: Well, you know, Jeff, while China's involvement in Russia and the scandal of the spy balloon has attracted a lot of attention here, inside China, the focus, as you said, has been very domestic. With all the COVID lockdowns, the economy grew only 3%―way below the target. But now that the Chinese government has lifted the COVID restrictions, and they pledged to boost domestic consumption and increase growth in 2023.

A number of recent articles have pointed out that investors have taken note of this and are again bullish on China. U.S.-based mutual funds and ETFs that focus on China have been seeing big inflows. So do you think investors are getting this right―should we all be looking at China as an opportunity with significant upside?

JEFF: You know, it's worth remembering that despite all the U.S.-China tension this year, stock market indexes in China and the U.S. are both up so far this year. A continued rise in geopolitical tensions is unlikely to have much impact on China's economic recovery. That's really been dependent on this domestic strength stemming from the post-COVID rebound in consumer demand. That's been the primary driver of China's stock market since that reopening began in November. In fact, China's stocks are up nearly 60% since then. Its only to be expected maybe that China's stock market might take a breather after that powerful rally, no matter how much optimism has started to show up among investors. We've got to await economic data that isn't distorted by the Lunar New Year―this year it took place in late January instead of early February of last year―that creates distortions in the monthly data. And, of course, there might be some policy stimulus announcements following the early March, the March 5 National People's Congress. And so we've got to keep an eye out for all of that. That could clearly influence stocks, maybe even more so than these tensions. China does not have an inflation problem right now. Inflation's low in China. It's got a lot of pent-up demand supporting some of that investor optimism. That said, investors may still want to limit their overall exposure to China—China's stock market is notoriously volatile, as that 60% three-month rally illustrates.

MIKE: What about emerging markets? Investors seem to be losing faith there. What's behind that?

JEFF: Typically, as goes China, so goes emerging-market stocks. China makes up 30% of the MSCI Emerging Market Index, and if we add in countries that are heavily influenced by China's economic momentum, like South Korea and Taiwan, we can get over 50%. Emerging-market stocks are up this year, but they're lagging developed-market stocks by a few percentage points. But, for once, this isn't China's fault—Chinese stocks actually are keeping pace with developed markets—it's mainly India's fault.

U.S. short-seller Hindenburg Research published a report that accused India's Adani Group of corporate fraud on an epic scale. Adani Group has rejected the claims in the report. But to a significant extent, the damage has been done. Since the Hindenburg report's January 24th publication, the MSCI India Index has fallen by 4%, and it's now underperforming the overall EM index by 9%, dragging it lower. India's one of the top five countries in that index.

Now, in time the allegations of fraud might blow over, much like earlier misgivings about India's GDP statistics. But even if India retains its status as the world's fastest-growing economy, India's valuation premium over emerging-market peers might erode as investors start to discount the potential for some accounting concerns.

MIKE: You know, Jeff, I think for investors it's easy to look at these headlines around the world and maybe overthink them as an investor. It can feel like geopolitical tensions are on the rise overall, but I'm not sure that that's true. Maybe I'll ask you if that's true. How should investors be thinking about geopolitical risk in their own investing strategies? What kinds of opportunities are there in the major global markets?

JEFF: Geopolitical threats flare up from time to time, and garner a lot of attention, but it's important to keep in mind that geopolitical risks are an ever-present part of investing. I mean, despite the recent news of geopolitical tensions, the risks aren't necessarily higher now than on average in the past. In fact, the Geopolitical Risk Index from the U.S. Federal Reserve Board is back to its long-term average after the spike tied to the war in Ukraine. But even when geopolitical risk is "average," it remains an important consideration. And that's one reason why it is important to diversify, which may lessen the heightened volatility that can result in certain industries or countries. Developed international stocks are outperforming U.S. stocks this year, as they did last year. It's an important reminder that even as nationalist tensions rise, looking beyond domestic borders may benefit portfolios.

MIKE: Jeff, what do you say to people who struggle with how to get involved in global investing, or they find it, maybe, intimidating. They think it's hard enough to stay up with U.S. equities on companies that we're generally familiar with. So what's the best way to get into the global markets, where there are so many choices that most investors maybe aren't as familiar with?

JEFF: Well, first, it's important to remember that we are familiar with the big companies that make up international markets. For example, Nestle is the biggest stock in Europe, Toyota and Sony are the top two in Japan, and the oil company Shell is number one in the United Kingdom. These are global companies we are just as familiar with here in the U.S. as in the countries they happen to be headquartered in.

There's a time to be very selective, for example, when international stocks are out of favor you may want to focus just on certain regions or industries where prospects are brightest. But that isn't the case now. Stocks headquartered in Europe and the U.K. and Canada and Japan, among other nations, are outpacing those in the U.S. so far this year after having done so in the last year, as well.

So broad international indexes, like the MSCI EAFE Index, which is tracked by many international ETFs and funds, offer broad diversified exposure to these global companies and may be a great way to get involved in investing internationally.

MIKE: Well, great stuff as always, Jeff. Thanks so much for making the time to chat today.

JEFF: My pleasure. Thanks for having me on.

MIKE: That's Jeff Kleintop. Follow his commentary and his weekly 90-second video on what to expect from the markets on Twitter, @jeffreykleintop.

Well, that's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks. So take a moment now to follow the show in your listening app so you won't miss an episode. And if you like what you've heard, leave us a rating or a review—that really helps new listeners discover the show

For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.

I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.