The drumbeat of US-China tensions is likely to crescendo in the coming months, with the relationship devolving across geopolitical, diplomatic and economic fronts. Evan Brown, Head of Multi-Asset Strategy Investment Solutions, and Luke Kawa, Director Investment Solutions of UBS AM note this in their new Macro Monthly.
From a market perspective, Chinese technology stocks could face significant volatility given escalating conflicts between the two sides. Meanwhile, conventional wisdom holds that the dominant market position and earnings power of US technology heavyweights are unassailable. However, investors should not lose sight of the big picture. We believe that any disruption over coming months could provide pockets of opportunity in Chinese technology stocks, which enjoy supportive underlying trends that include a deep, captive domestic base and a government committed to the development of technology champions as well as macroeconomic stability. The pandemic has likely accelerated technology adoption and pulled forward digitization. This thesis has been embraced much more by investors in US IT stocks compared to their Chinese peers, judging by the relatively muted earnings outperformance vs. the benchmark expected for the latter over the next 12 months.
Outstripping Chinese IT stocks have typically traded at a meaningful premium to their US rivals on a forward price to earnings basis, though this has materially ebbed since the start of the trade war in 2018. Higher valuations are also indicative of the past cycle’s trend in earnings growth, with Chinese IT handily outstripping its US counterpart. And compared to other Chinese equities, tech stocks aren’t at historically stretched levels, in stark contrast to the setup stateside. The MSCI USA IT index has a multiple that’s two standard deviations above that of the MSCI USA based on the past decade of observations; the comparable premium for MSCI China IT is only modestly above average. Pure IT is a relatively limited part of the MSCI China Index, but this differential in the relative valuation premium also generally holds for some of the biggest companies in these markets, like Alibaba and Tencent in China and Amazon and Microsoft in the US.
The US tech sector is the preeminent source of software stocks globally, which account for one-third of the index and can exhibit defensive characteristics during periods of economic stress. China’s tech sector is more physically oriented, with nearly 60% weighted in technology hardware and equipment. Semis account for just more than one-fifth of the tech sector in China, and a little less than that level in the US. This industry composition would also tend to work more in China’s favor at the onset of an early cycle environment.
Please read UBS Asset Management’s full Macro Monthly here.