Investors face a radically different global landscape that demands a fundamental rethink of the approach to investment. As we have been arguing over the past couple of years, the all-encompassing contest between the incumbent superpower, the US, and the rising challenger, China, is set to redefine the world political and economic order.

The week I have just spent in Washington has left me more convinced than ever that we are at the end of the beginning of The Great Decoupling, irrespective of the outcome of the US presidential election in 2020. This presents a serious challenge for any investor who lacks a blueprint to blend geopolitical research with macroeconomic, valuation and technical analysis.

More importantly, the Digital Cold War we forecast has no precedent. During the first Cold War the world economy and financial markets were far less integrated than today. And, of course, the internet had not been invented. Modern technology has reshaped not only how the economy and markets operate but also what constitutes a national security risk.

Assuming no change of regime or ideology in either China or America and no military confrontation, we face a prolonged, messy decoupling which will ebb and flow depending on the dominant issues of the day and which policy stakeholders in both countries have the upper hand.

In this Enodo Insight, I’ll outline some of our views on how this will transform the investment environment over the next five years and what you need to consider to stay on top of this profound change.

Alibaba versus Amazon

In a world bifurcating into American and Chinese spheres of influence, two critical issues stand out for a global investor: which economic and political model offers higher returns, and where will the underlying assets be safer. In coming to a judgment, don’t take free movement of capital for granted.

Take Amazon and Alibaba. On the face of it, assuming equally attractive valuation entry points, Alibaba might appear to offer better growth prospects for the long-term investor.

A near-monopoly at home and likely to remain one within a Chinese sphere of influence, Jack Ma’s brainchild enjoys full state backing as long as the firm toes the Party line. By contrast, in the West technology giants like Amazon are coming under increasing scrutiny from politicians and regulators worried about unfair competition.

In China, technology and e-commerce firms benefit not only from subsidies and preferential treatment but also from an absence of data privacy. Data is the most valuable asset of the future and the Party has every intention of using it fully to its own advantage. The West is taking a different approach, broadly respecting its citizens’ right to data privacy.

But for the owners of capital, China’s recommitment to Marxism-Leninism is ultimately not good news. In both China’s and America’s spheres of influence, policymakers will need to address growing income inequality. In China’s communist regime, however, the owners of capital can be sure they will be the last in the queue during the coming global redistribution of income.  

A Digital Cold War will make financial integration and the free movement of capital between the two spheres hard. Beijing’s pledge to open its financial sector to foreign capital and competition does not sit well with its determination to fence off its internet via the Great Firewall of China.

Relative price adjustment versus cost-push inflation

The disruption of integrated supply chains and the free flow of capital will create new corporate winners and losers in each sphere of influence. These forces will be critical in shaping macroeconomic outcomes. The rerouting of international supply chains and global savings points to cost-push inflation and a higher cost of capital across the board, but these developments are likely to play out differently in America and China.

After China’s entry into the WTO in 2001, many US firms shifted production to China, attracted by cheap labour and economies of scale. Some industries are unlikely to return, but reshoring will make sense for others. We will publish our analysis of which manufacturing sectors are most likely to move back to the US in the next few weeks.

In the first instance, the impact of tariffs can be viewed as a relative price adjustment, with higher costs set to eat into US real consumer incomes. 

We have discussed why Chinese exporters are unlikely to cut their export prices much.

Despite sizeable profit margins, US firms do not appear willing at this stage to absorb the cost of tariffs. On our estimates, nearly half of what US consumers pay at the till for goods imported from China, including intermediate inputs, is accounted for by value added generated in the US.

At this stage, the Fed is much more likely to ease policy to fight demand deflation. But, as global supply chains are unwound and rerouted, a process that will take years to play out, the result will probably be cost-push inflation not just a relative price adjustment.

As firms begin to move some production back to the US, cost-push inflation will take the form of higher nominal wages. This is one way to achieve the necessary redistribution of income between labour and the owners of capital.

In its quest to industrialise at breakneck speed after joining the WTO, China was happy to export much of the output of its booming manufacturing sector. To hasten the country’s industrial expansion, policymakers repressed households financially by keeping interest rates artificially low.

Fast forward to today and Beijing is keen to support the domestic consumer. It has enjoyed some success, as we have explained in other reports. Most of the goods China consumes are produced at home. But the transition from an export-led to a consumer-led economy in coming years will be far from easy.

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The return to the old model of investment-heavy, credit-fuelled growth that is now under way is set to hobble the economy’s necessary rebalancing towards consumer spending. It also bodes ill for China’s attempts to reduce its overall debt-to-GDP ratio. So, in the first instance, the erosion of its role as a global manufacturing hub, combined with the difficulty of fostering household consumption in the face of reduced access to world markets, is likely to hurt nominal labour income in China as unemployment rises.

If Beijing fails to boost productivity growth substantially through structural changes in order to absorb years of excessive investment and the rapid build-up of debt since the global financial crisis, a weaker exchange rate will eventually become the only pressure release valve. But currency depreciation will also be a conduit for cost-push inflation in China.

Demand-pull inflation is defined as too much money chasing too few goods. Cost-push inflation can be defined as too many claimants chasing too little income. As China and the US decouple and each has to deal with income inequality, I find it hard not to envisage the next five years as a period in which too many claimants will indeed be chasing too little income.