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WashingtonWise Investor: Episode 22

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US-China Tensions Grow: Are Markets Concerned?

Relations between the U.S. and China have deteriorated, and both sides continue to throw fresh fuel on the fire. How much is the growing divide impacting markets, and what are its long-term implications?

In this episode of WashingtonWise Investor, Jeff Kleintop, Schwab’s chief global investment strategist, joins Mike to discuss the heightening tensions between the U.S. and China and what it may all mean for the markets. They discuss long-brewing concerns such as the potential delisting of Chinese companies from the U.S. exchanges and China’s purchase of U.S. debt, as well as more recent issues, including China’s security crackdown on Hong Kong and growing tensions between China and Taiwan.

Mike also provides insight on the approval by Congress of changes to the Paycheck Protection Program for small businesses, offers an update on the prospects for another major coronavirus aid bill; and discusses the ever-evolving implications of the coronavirus pandemic on the 2020 election.

WashingtonWise Investor is an original podcast from Charles Schwab.

If you enjoy the show, please leave a rating or review on Apple Podcasts.

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MIKE TOWNSEND: Like most of you, I’ve spent the past the three weeks on a rollercoaster of emotions. Pride and admiration for the millions of Americans who have peacefully protested in cities and towns of every size around the country, including my own home of Washington, D.C., as well as frustration at the violence and disruptions we’re seeing.

The events of the past couple weeks are outside the scope of this podcast, and I’m not planning to address them in detail. But before diving into this week’s content, I wanted to acknowledge the significance of the events of the past three weeks and express my concern and sympathy for everyone who continues to be affected.

Welcome to WashingtonWise Investor, an original podcast from Charles Schwab. I’m your host, Mike Townsend, and on this show, our goal is to cut through the noise and the nonsense of the nation’s capital and help investors understand what’s really worth paying attention to.

On today’s episode, I’m going to explore the changing dynamics of the relationship between the United States and China over the last several weeks—and what that might mean for investors. My colleague Jeff Kleintop will be joining me for that in just a few minutes. But first, let’s take a look at a couple of other stories making news right now.

Last Friday, the president signed into law the Paycheck Protection Program Flexibility Act, the latest example of Congress coming together quickly to approve a piece of pandemic-related legislation with overwhelming bipartisan support.

The Paycheck Protection Program was one of the cornerstones of the CARES Act that Congress passed in late March. It offers forgivable loans to small businesses to help them through the pandemic. As of the beginning of this week, more than 4.5 million businesses had received more than $510 billion in aid.

But over the last couple of months, it became clear that there were some serious flaws with the program—flaws that were leading some small businesses to decide to not even apply for a loan.

The bill approved last week makes two important changes to the program. The first is that it extends the amount of time a business can use the loan funds from eight weeks to 24 weeks. This was the driving force behind the urgency to get this bill finished, because for the businesses that received loans in the first days after the program launched in early April, that eight-week period was about to end last weekend.

Now businesses can use those funds for much longer. The second provision reduced the percentage of funds that must be used for payroll from 75% to 60%. The 75% threshold was designed to ensure that small businesses used most of the loan funds to keep employees on the payroll, even while the business was temporarily shuttered due to the pandemic.

But many companies, particularly those in high-rent cities like New York, San Francisco, Washington, and many others, found that 25% of their loan funds did not cover their monthly rent. And it made no sense to require companies to spend funds on payroll if the business couldn’t pay the rent.

The House passed the bill 417-1 on May 28, and the Senate approved it unanimously on June 3. President Trump signed it into law on June 5. Now we will see whether the number of new businesses applying for loans ticks up in the next few weeks as some of barriers to the program have been lowered.

Meanwhile, the timeline for Senate consideration of a larger coronavirus aid package has continued to slip. While House Democrats passed the $3 trillion HEROES Act on May 15, the Senate has not only not considered the bill, but has shown little interest in even proposing an alternative.

And last week, Senate Majority Leader Mitch McConnell said that there is no plan for the Senate to consider a coronavirus aid and economic stimulus package until after the Senate’s planned two-week recess in July. The Senate is currently scheduled to be in recess for the weeks of July 6 and July 13, meaning that consideration of a bill would not come before the week of July 20.

A key deadline Congress is facing is the July 31 expiration of the enhanced unemployment benefits that Congress approved back in March. If the Senate does not even consider a bill until the week of July 20, that could make it difficult to finalize an agreement by July 31.

But Republican leaders in the Senate argue that last week’s surprise jobs report, which saw the unemployment rate fall in May from 14.7% to 13.3%, validates their “take it slow” approach. Senator Charles Grassley, a Republican from Iowa who chairs the Senate Finance Committee, the committee that will take the lead on any coronavirus aid bill, said on June 5, “The jobs report underscores why Congress should take a thoughtful approach and not rush to pass expensive legislation paid for with more debt before gaining a better understanding of the economic condition of the country.”

Other Republicans had pointed out that a significant portion of the more than $2 trillion allocated as part of the CARES Act has not even begun working in the economy yet, including the $600 billion Main Street Lending Program for mid-sized business with between 500 and 15,000 employees. The Federal Reserve is expected to launch that program this week.

Democrats argue that delay just makes things more difficult for states and municipalities that are facing a major cash crunch due to the lack of tax revenue and the increase in outlays since the outbreak started. More money for state and local governments is the centerpiece of the HEROES Act, and many Senate Republicans support getting money to states and municipalities soon. For now, though, Republican leaders in the Senate appear content to push the date for action out another month.

On my Deeper Dive this week, I want to take a closer look at the U.S.-China relationship, which has seen a number of dramatic developments since January. Joining me to provide his perspective on these issues and their implications for investors is Jeff Kleintop, Schwab’s chief global investment strategist.

Jeff, thanks so much for joining me today.

JEFF: Great to be with you, Mike.

MIKE: Well, Jeff, there’s so much going on with the U.S.-China relationship right now that I want to dive into with you, but let’s first get something out of the way, and that’s this issue of the U.S. stock exchanges possibly delisting Chinese companies. It’s something you and I have been getting a lot of questions on from investors who are worried that the shares that they hold in Alibaba or other foreign companies could be impacted. So let’s be clear right up front—that is not going to happen anytime soon.

Last month, the Senate unanimously passed a bill that would ban foreign companies from the U.S. capital markets if U.S. accountants are unable to review the audits of those companies. The House of Representatives may consider the bill later this summer. But even if it passes Congress and is signed into law, and even if the SEC quickly writes the rules necessary to implement it, investors need to understand that a company would be delisted only if it failed to share its audits with U.S. regulators for three consecutive years. Realistically, we are talking a minimum of three to four years before any company would actually be delisted. 

So Jeff, with that context, this is an issue that’s been floating around for years now. Why did this come to be a front burner issue all of a sudden? Is this just another way to poke China in the eye?

JEFF: That’s probably a good way to put it. It seems to be a way to take aim at China without any immediate consequences. You know, Chinese stocks have posted gains as this has been moving through D.C., if that is any indication of the impact.

The SEC has been saying for years that China has been unwilling to give U.S. regulators routine access to perform audits of Chinese companies. Back in 2013, China’s SEC, the Chinese Securities Regulatory Commission, said they would do the audit and send the SEC the paperwork. Unsurprisingly, that didn’t resolve the issue.

Now this isn’t a big hurdle for the companies themselves; it’s just a decision by China to allow U.S. auditors into the country to do an audit when requested. And there’s about 233 Chinese companies that this would apply to. And these are big companies that generally use one of the world’s top four accounting firms. In fact, research has shown that Chinese ADRs are more likely to be associated with a Big Four auditor and less likely to restate prior-period financial statements than ADRs from other countries. So you know, it’s not really an issue for the companies themselves.

Now momentum to these efforts comes from Luckin Coffee, which did an initial public offering on the Nasdaq last year and then was delisted this year after an investigation revealed the Chinese company fabricated some sales. So does accounting fraud does happen in China? Yes it does. But of course, it also happens here. Now it’s worth noting that U.S. accounting standards and audits aren’t a guarantee against fraud. Just ask former investors in huge U.S. companies like Enron or Worldcom or Tyco and many others.

So this appears to be a way to poke China in the eye, as you put it, and I don’t see this as a big issue for markets or investors any time soon.

MIKE: So this delisting issue is a specific example of the larger deterioration of the relationship between the U.S. and China. A key aspect of that relationship is trade. It’s hard to believe now, but the U.S. and China signed what became known as the “phase one” trade agreement just back in January, just as the coronavirus was first entering the public consciousness. So how would you describe the current state of the trade relationship?

JEFF: Well, despite the animosity between the so-called good friends, Presidents Trump and Xi, the deal still stands. I mean, the breadth of the disagreements between the U.S. and China has certainly grown over the months—I mean, now it’s encompassed Hong Kong, and technology, and immigration among other issues. But the primary focus of the disagreements in the last couple of years have been the trade issues. And that phase one trade agreement has largely been been left alone. President Trump may have some incentive to avoid upending his signature achievement with China.

But with a close election coming up, I expect the heated rhetoric around these issues to remain, especially as the recovery progresses. And at some point those disputes may spill over to the stock markets, as they did last year.

MIKE: Well, is China honoring the phase one deal? What are the ramifications if China fails to hit the targets for purchases of U.S. products that are in that deal?

JEFF: Ah, well, yes and no. China is attempting to make good on its pledges during a global recession, but it is falling well short of the targets of the two-year deal.

Imports by China from the U.S., especially of agricultural products, picked up in the last couple of months based on the data we have from both countries. But the drop in prices due to the recession has made hitting those dollar targets much harder since it requires purchasing an even greater quantity than was anticipated when the deal was signed back in January in order to meet that target.

Now the ramifications of missing the targets are that the U.S. can ratchet up tariffs. Per the terms of the agreement, a complaint by one party would trigger meetings between officials of both sides. If the two sides can’t resolve the matter within about 90 days, the accusing side can impose tariffs, and the other’s only recourse would be to leave the agreement entirely.

But since the deal sets no fixed terms for further Chinese purchases of American goods after 2021, if pushed, I guess China might simply pull forward imports from the first half of 2022 into late 2021 just in order to meet the terms of the agreement and leave China’s imports from the U.S. to fall off a cliff in 2022.

Not to turn the tables on you, Mike, but I suppose a lot will depend on who wins the 2020 U.S. election as to how that might be handled.

MIKE: Well, it’s no question about that. I expect the U.S.-China relationship to be one of the major issues of the campaign. From President Trump’s perspective, the trade deal was something he sees as one of the signature accomplishments of his presidency, yet the dynamics between the two countries are so different than they were when that deal was signed back in January. It’ll be interesting to see how this plays out in the context of the campaign.

Well, Jeff, another piece of this puzzle that you’ve already mentioned has been the turn of events with regard to Hong Kong. First, give us a little background on exactly what China is doing that has provoked so much outrage.

JEFF: You know, to focus on one piece of legislation or another kind of misses the point. Hong Kong is resisting China’s attempts to impose more control over their institutions, in various forms.

China’s leaders know that to succeed, China must have its own world-class financial center, and Shanghai or Shenzhen just don’t make the cut. And this is clear from Alibaba’s decision to pursue its secondary listing in Hong Kong last year, after its initial listing on the New York Stock Exchange back in 2014. China’s leaders tried all they could to encourage Alibaba to list in Shanghai. But when push came to shove, a riot-torn Hong Kong last year still won out. But a substantial chunk of Hong Kong’s population harbors hostile feelings towards the mainland. And this leaves China’s ruling party with a quandary: Can a separate Hong Kong, where parts of the population are openly unfriendly to China, be trusted going forward to be China’s much-needed source of investment capital?

It seems that Chinese policymakers have decided that the structure for governing Hong Kong must be changed and that China will need to exert more, not less, control over Hong Kong’s institutions. And naturally, those citizens used to the independence of “one country, but two systems” object to this challenge to their freedoms.

MIKE: Well, in response to these developments, the U.S. is ending Hong Kong’s “special status”—what are the implications of that?

JEFF: Well, so far it’s pretty vague. There’s not a lot of specifics. There’s a big difference in economic and market impact between simply changing visa rules and imposing tariffs that would undo decades of economic interdependence.

You know, the practical matter of extending the U.S.-China trade tariffs to Hong Kong is that it disproportionately hurts the U.S. You know, unlike the trade deficit between the U.S. and China’s mainland, the U.S. has a trade surplus with Hong Kong. So damaging this relationship likely hurts the U.S. more than China, making it an unlikely course of action. But whatever the changes, Hong Kong has already taken a number of hits to its status as an attractive headquarters for business and finance over the last year.

MIKE: Another island with, let’s call it a “unique” relationship with China, is Taiwan. China’s relationship with Taiwan has been tense for decades, but recently there has been an escalation in those tensions with Chinese military exercises in the Taiwan Strait, murmurs from some Taiwanese leaders about formal independence, and an unusually public statement of support from the U.S. Secretary of State to Taiwan’s president. Do you think China’s actions with regard to Hong Kong could be a precursor to a tougher stance with Taiwan?

JEFF: There are plenty of areas of China that wish to be independent. If it appears some are having success at this, others may try to pull away, as well. So every action will be met with a reaction. China sees this as an existential risk.

MIKE: Well, let me ask you more broadly about China’s growing influence around the world, particularly at a time when the United States seems to be stepping back from the world stage. An example is China stepping up to support the World Health Organization just as the United States announced its plans to withdraw completely from the WHO. Even before the pandemic, China was aggressively building relationships, not only in Asia, but in places like Africa and South America. So what are the implications of this changing power dynamic?

JEFF: As the U.S. pulls back from more and more global institutions, it creates an opening for China to take a bigger role and shape the global stage to better suit their objectives. The ability of the U.S. to act as a counterweight to China’s influence in developing and frontier countries is fading.

This may not have material near-term consequence, but when you consider that given demographics, by 2050 these countries in Africa and South America may be the world’s biggest consumer markets, and it could therefore have very significant long-term consequences. You know, with one political party and a president for life, China plays the long-term game.

MIKE: Well, another issue that seems to be always on the minds of investors is the fact that China is the largest purchaser of U.S. debt. With the federal budget deficit now projected to exceed $4 trillion, and the national debt skyrocketing in the United States due to the pandemic response, is China’s willingness to buy more or less U.S. debt a concern for the U.S. economy? The way investors often ask this question to me is whether China has too much leverage over the United States because of its role as the largest purchaser of U.S. debt.

JEFF: Well, China is one of the biggest holders of U.S. debt, but it’s been a while since it increased its holdings. In fact, China’s holdings of U.S. Treasuries has fallen by nearly 20% since it peaked back in 2013, and much of that came in the past year.

With the U.S. buying less China-made goods over the past year due to the trade tariffs, China has just had fewer dollars to buy U.S. Treasuries with. 

On the plus side, we’ve seen that even a major holder of Treasuries like China can substantially reduce their holdings and, as long as the Fed is buying unlimited amounts, it hasn’t seemed to have an impact on interest rates.

MIKE: Well, that does seem to be true. Jeff, let me end with this: There’s so much uncertainty around the world right now. The pandemic is still very much with us and is affecting different countries in different ways. The protests for social justice that have dominated headlines here in the United States for the past couple of weeks have spread to many other countries. Yet the market seems unfazed by all of this uncertainty. What’s your take right now on investing opportunities globally, but particularly in China? 

JEFF: Historically, periods of civil unrest and high unemployment go hand in hand. Yet, unemployment and stocks are uncorrelated. You know, on a monthly or year-over-year basis, there is simply no consistent relationship between the change in jobs and the change in the stock market. That isn’t because Wall Street doesn’t care about Main Street. It’s because history shows that the stock market tends to lead the trend in jobs. The market is seeing increasing signs of recovery globally.

And with China and South Korea leading the global economic recovery—remember, they were the first into the COVID-19 downturn and the first to emerge—and they make up about 50% of the MSCI Emerging Market Index, and therefore, it’s not too surprising that emerging market stocks have been outperforming in recent weeks.

Historically, it’s not uncommon for emerging market stocks to lead the rebounds from bear markets. You know, during the last global recession in ’08 and ’09, emerging market stocks bottomed in October of ’08, six months before the U.S. stock market bottomed. And the one before that, back in the global recession of 2000 to 2002, emerging market stocks bottomed in September of 2001, just after 9/11, bottoming well before U.S. and other developed markets.

You know, for all the concerns about the U.S.-China relationship and the protests here and in Hong Kong, two of the best performing stock markets in the world this year are the U.S. and China—and they’re just about back to even on the year. So it just goes to show you how headlines are often a poor tool when it comes to investing.

MIKE: Well, Jeff, you’ve given us a lot to think about and answered some great questions about the situation between the U.S. and China. I really appreciate you joining me.

JEFF: Anytime, Mike.

MIKE: You can find consistently great content from Jeff on the Insights tab on Schwab.com, but I highly recommend in particular his 90-second video commentary each week on what Schwab is watching in the markets. It posts every Monday and gives you three or four things to keep an eye on in the week ahead. But one of the best parts is that he does his own illustrations to go along with his comments. You can follow Jeff on Twitter @JeffreyKleintop.

On my Why It Matters segment, I want to highlight a decision last week by the Department of Labor that opens the door for retirement plan participants to invest in private equity funds. Such funds are typically reserved for wealthy investors and institutional investors, as they often involve investing in private companies and come with more risk. They have long been inaccessible to participants in a 401(k) or similar plan, but guidance issued by the department will change that.

In announcing the decision, Labor Secretary Eugene Scalia said the move would “ensure that ordinary people investing for retirement have the opportunities they need for a secure retirement.” Pension funds have the ability to invest retirement dollars into private equity investments, but there’s been a general shift away from defined benefit plans toward defined contribution plans over the past two decades, and most individual retirement savers don’t have access to these investments.    

While the Labor Department guidance outlines the requirements for a plan to make such investments available, there is no requirement that a plan do so. Indeed, many plans are wary of allowing less sophisticated investors to invest in products that may be more volatile than other retirement savings options.

But the SEC supports the plan, which dovetails with its own efforts to make it easier for ordinary investors to invest in private equity. For years, such investments have only been available to wealthier investors who are designated an “accredited investor” by the SEC. The SEC has proposed easing the long-standing definition of who qualifies as an accredited investor in order to make those investments available to more people.

It may be some time before we know how many plans make these kinds of investments available to plan participants, but the door is now open for that to happen.

Finally on my Election 2020 update, a couple of tidbits. First off, former Vice President Joe Biden officially secured the Democratic presidential nomination last week. This was, of course, largely symbolic, as Biden was already the last candidate standing. But in order to claim the nomination, Biden needed to collect 1,991 delegates. On June 2, seven states and the District of Columbia held their primaries, many of which had been postponed from earlier in the spring by the coronavirus pandemic. On Friday, June 5, as counting from those primaries continued, it was announced that Biden had crossed the magic line. And by June 8, Biden had amassed more than 2,000 delegates. Ultimately, the development doesn’t change the race at all. But we can stop referring to Biden as the “presumptive nominee” and just refer to him as the nominee. Biden will formally accept the nomination at the Democratic National Convention, scheduled for the week of August 17.

The other notable thing about last week’s primaries is that they served as a sort of dry run for what voting will be like in November. A total of nine states plus the District of Columbia voted on June 2. In addition to the presidential primaries in seven states and D.C., there were two states that had Congressional and other primaries, but their presidential primary had already taken place. In every state, a majority of the ballots were cast by mail. In Maryland, for example, 97% of voters voted by mail—as compared to 4% of voters who did so in the 2016 primary. Pennsylvania, a critical battleground state in November, went from 2% voting by mail in 2016 to 64% doing so in 2020.

In some states, turnout set records for a primary, and that’s likely attributable to voting by mail.

But the news was not all good. Many states saw long lines at polling places for voting in person, a process that was made much more cumbersome by social-distancing rules. Some states had fewer polling places open—in part due to a lack of poll workers willing to come in and staff those polling stations. If the coronavirus is significantly impacting life come November, this could be a real issue, since poll workers tend to be older and thus potentially more susceptible to the virus. Some of these workers simply did not feel safe working the polls.

But I think one of the most interesting lessons of last week’s primaries is how long it took some states to count ballots. Parts of Pennsylvania, for example, were still counting votes a week after its primary.

And some states have rules that say a ballot need only be postmarked by Election Day, which means some ballots are still arriving at election headquarters days after the election.

All of this raises the possibility that we may not know the outcome on Election Night, November 3. Or the next day, November 4. Or for days afterward. We may not know who won the presidency, or which party prevailed in what is shaping up as a razor-thin margin for control of the United States Senate.

And that’s something that makes a lot of people nervous. As investors it’s something to keep an eye on, as the markets could become volatile in the fall if there is uncertainty as to the election’s outcome.

Well, that’s all for this episode of WashingtonWise Investor. We’ll be back with a new episode on June 25.

Please take a moment to subscribe so you don’t miss an episode. And if you like what you’ve heard, leave us a rating or a review on Apple Podcasts or your favorite listening app—those ratings and reviews really matter.

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 Investor. Wherever you are, stay safe, stay healthy, and keep investing wisely.

Important Disclosures:

The policy analysis provided by Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For more information on indexes please see www.schwab.com/indexdefinitions.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

All corporate names and sectors are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.

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