Global supply chains are not unraveling but COVID-19 is hastening their evolution, which merits investors’ attention.

Anti-China rhetoric is nothing new in the U.S. But COVID-19 has lent it a new talking point, exacerbating existing tensions and igniting fears that strained U.S.-China supply chains could finally come undone. That’s a big if. We’ve seen surprisingly little evidence yet that global supply chains are unraveling despite the COVID-19 war of words, alarming headlines and a multiyear U.S.-China trade and tech battle.

Yet, despite scant evidence that U.S.-China tensions have stressed global supply chains—and while COVID-19’s impact remains uncertain (more on this below)—other supply chain trends are important for investors to understand:

  • Some production has been forced out of China, reducing China’s exports to the U.S.
  • Manufacturers are diversifying their supply chains.
  • China’s drive for self-sufficiency and localization has accelerated, with implications for neighboring economies.
  • The 2020 U.S. presidential election could potentially be a pivotal moment in global trade, as Joe Biden’s economic policy calls for U.S. self-sufficiency in the industries of the future

As the trade and tech war sagas take new turns, we separate truth from hype and point to the positives and negatives investors should understand.

Despite the frenzy among market participants about the U.S.-China trade war, the gains to global trade made from the early 1990s to about 2007—the era of “hyperglobalization”—have held up well (see chart below).

U.S.-China trade tensions have not reversed “hyperglobalization”

Source: Netherlands Bureau for Economic Policy Analysis/Haver Analytics. Data as of February 29, 2020.
The chart displays the ratio of global trade to global industrial production from the 1990’s through now. It indicates, that in the early 1990s to about 2007—the era of “hyperglobalization”, that globalization increased. From 2007 to now, the gains have remained steady.

We also see the trade war as having relatively muted effects on global supply chains. That’s largely because firms respond more to commercial considerations than political rhetoric when deciding where to locate production—and the trade war has done little to change the business rationale for manufacturing in Asia. At the margin, supply chains are shifting within Asia (more on this below) but very little of it seems to be coming back to the United States or Europe. Rather than a tale of political tensions, the story is one of trade maturation, as China’s economy becomes more consumer-oriented and technologically advanced. One longstanding structural change illustrates this ongoing evolution: Total foreign direct investment (FDI) into China as a share of total Chinese GDP has been declining for the last 10 years.

But there have been supply chain impacts, just not the ones in the headlines.

  • Stress on U.S.-China—but not global—supply chains: China-U.S. trade tensions under the Trump administration cannot be ignored. U.S. imports from China took a hit as higher tariffs and the rise in trade war and tech war tensions forced some production out of China, reducing China’s U.S.-bound exports and causing a big drop in U.S. import spending on Chinese goods.

    However, if we focus on just IT and electronic goods, the largest category of imports sourced in Asia, U.S. protectionist policies are clearly not reducing dependence on goods produced in Asia or other emerging markets. In fact, the share of all U.S. imports originating in emerging markets ex-China has gone up visibly (middle portion in the chart below) over the past two years. So while China-U.S. bilateral trade flows have been impacted, global supply chains remain unscathed (for now).

The United States is importing fewer Chinese goods

Source: Census Bureau. Data as of July 28, 2020.
The chart displays the share of all U.S. electronic imports originating in emerging markets (EM), developed markets (DM) and China from 2002 through 2020. During this time period, Emerging markets (EM) has gone up over the past two years.
  • Production capacity is moving to China’s neighbors: There is no evidence that multinationals moving offshore production out of China are automatically re-shoring back to the U.S. or other developed markets. Rather, firms appear to be diversifying capacity, often by moving into neighboring lower-wage economies.1 While China’s exports to the U.S. dropped, its exports to other countries—especially emerging markets—increased. China has become a crucial supplier of components that lower-cost producers, such as Vietnam, are now assembling (see chart below). Anecdotal evidence suggests some savvy Chinese manufacturers may have moved production to avoid tariffs.

Chinese components are being assembled in lower-cost Vietnam

Source: General Statistics Office of Vietnam. Data as of July 28, 2020.
The graph displays the China foreign direct investment (FDI) into Vietnam from 2010 through 2020. China It indicates that over this time period, China’s FDI into Vietnam has increased.
  • Chinese localization has dramatically accelerated: China’s self-sufficiency drive—to substitute domestic production for imports—is often overlooked, but will perhaps prove the most important shift in the long term. China’s share of global imports is rising more slowly than its share of global exports, suggesting more local content in its exports. The declining import-intensity of China’s growth also points to more domestic production and consumption.

    This is not just a technology supply chain phenomenon. Take heavy industry: Foreign brands dominated the Chinese excavator market before the financial crisis but local brands have gained market share. Now about 60% of excavators sold in China are local brands. Retail has felt the impact, too—the trend is similar in cosmetics. In 2010, foreign brands accounted for 70% of China’s “mass” cosmetics market. By 2017, that share had fallen to 46%. As countries such as the United States and Japan provide companies with economic incentives to bring manufacturing home, and China seeks greater self-sufficiency, the localization trend could accelerate.

Excavator sales in China by brand

Source: The Press Finishing. As of July 31, 2020.
The line graph shows the excavator sales in China by brand, local brand and foreign brand, from 2009 through now. It indicates that during this time period, local brand market share has increased and foreign brand market share has decreased.

As China imports less and localizes production, its growth could become less complementary for the rest of the world, presenting challenges for countries along the supply chain that rely on Chinese demand, particularly emerging markets. Some Southeast Asian countries are benefitting from a production shift but as Chinese growth becomes more inwardly focused, there will be fewer opportunities for other countries to benefit.

Moving up the value-added chain has its merits. However, if the cannibalization or duplication of existing supply chains is done for reasons other than economic efficiencies, the result could be fewer economies of scale, higher costs and lower profitability. While the localization trend has been ongoing in China for some time and will likely accelerate, as geopolitics increasingly influences where countries produce and purchase their goods the downside from supply chain duplication could be felt more broadly.

While the trade war didn’t reverse globalization, COVID-19 exposed vulnerabilities in the U.S. supply of critical goods, supporting the notion that the United States is too reliant on Chinese manufacturing—which underlies Democratic presidential candidate Joe Biden’s proposed economic policy.

China has been a critical supplier of medical supplies to the U.S. during this crisis, leading to calls for rethinking supply chains’ concentration in China in critical sectors. This aligns with Biden’s plan to push for self-sufficiency by repatriating critical supply lines (for example, healthcare and national defense) and cultivating the domestic industries of the future (such as battery technology and artificial intelligence) through tax incentives, R&D investment and federal purchasing.

It’s impossible to say today if those changes will occur under a future administration. For the moment, however, amid the political rhetoric surrounding supply chains, surveys of private sector firms show a mix of responses regarding their intentions for altering their supply chains. Some surveys suggest COVID-19 has had a material effect on firms’ intention to move production out of China, while others don’t.2 Surveys of firm intentions are important, in our view, but hardly conclusive. If a version of Biden’s policy comes to pass, self-sufficient U.S. and China economies would lead to a bifurcation of the global economy. That would support the “China plus one” strategy already occurring at some multinationals that are diversifying their supply chains to include a second location. The incentives would include lower transportation costs, secure supply, quality infrastructure and the availability of skilled labor in the second (often domestic) markets.

While global supply chains aren’t unraveling, they are evolving, which merits investors’ close attention. Should they actually break down—which we don’t anticipate—corporate profitability could take a significant hit. Degraded supply chains would also lean against our core view (see Why you shouldn’t fear inflation or government debt) that inflation should remain well-behaved, despite unprecedented money printing by central banks and, in many countries, fiscal deficits that recall a wartime footing. We have a positive outlook for China’s domestic economy and the companies helping drive the country’s rise up the value chain.

As the United States and China compete, there could be a silver lining. Both countries have a high degree of fiscal flexibility when it comes to spending on domestic and industrial priorities, and a bigger fiscal thrust would help the global economy, mired in a state of slack and demand weakness for nearly 10 years. The COVID-19 shock only strengthens that case. It’s worth remembering that the Cold War-era space race, in which the United States and Soviet Union competed across virtually all emerging technologies, resulted in one of the most innovative periods in modern history.

Along the supply chain, challenges could lie ahead for emerging market economies outside of Asia losing market share as China pursues import substitution. Some U.S. and European exporters may fall into this category, as well. Our outlook is selectively positive for Southeast Asian economies, though, as recipients of the shifts in FDI and global supply chains.

1 One version of this shift is the so-called “China plus one” model in which global producers maintain some production in China while adding capacity elsewhere in Asia, in another emerging region or by building new manufacturing facilities in their home countries.

2 According to a UBS survey, more than 40% of CFOs with businesses in China say COVID-19 increases their intention to relocate production out of China. (Keith Parker, “Supply chains are shifting: how much and where?” UBS, June 15, 2020.) Conversely, a study by PwC and the American Chamber of Commerce in the People's Republic of China found that 92% of U.S. companies surveyed either had no intention to relocate as a result of COVID-19 (40%) or were unsure (52%). (“AmCham China Flash Survey Report on the Impact of COVID-19,” AMCHAM China, February 27, 2020.)