The consequences of China's rise and the decline of the West

In our first episode we analyzed the relative decline of the economic power of the West and the rise of China. We now want to zoom out and analyze the consequences of the changing world order.

We will divide the analysis into two parts: the inevitable consequences and the possible ways the West and China will react to it. Finally, we will then dive deep into what this means in practice for companies by analyzing each possible scenario and discuss in detail how companies and investors can take advantage.

The inevitable consequences

The first inevitable consequence is the rise of a multipolar world. The West, led by the United States has enjoyed a total economic, technological, military and cultural monopoly since the end of WW2 (with a brief parenthesis during the Cold-war period) until recently. And if we slightly change the definition of the West, we could go back much further and say that Europe enjoyed world hegemony since the first industrial revolution in England in the 1700s. We could therefore say that for the first time in 300 years the West will need to accept a new reality: it does not dominate the world anymore. The West has been so used to having considerable power when dealing with other countries and being the rule maker, rather than being subject to norms created by others. This is changing and it's about to change considerably. Countries are now starting to hedge their position: whereas before they were forced to be aligned with West by default, now they have a 'choice' whether to align with China or the West. Countries which are most economically dependent on China will pick that side and the same goes without saying for countries that have been having an adversarial relationship with the West. Some countries will want to play both sides, although this will be harder over time, and might be forced to choose. This is extremely significant because it means that for the first time in more than 50 years the world will be divided into two blocks with a different set of rules, effectively killing globalization. We will then dive deep into what this means in practice for western companies and how to best react to this change.

The second inevitable consequence is the intensification of the new Cold War (we call it Cold War II), which in our opinion started in the late 2010s. The US and China are competing harshly to gain edges over each other on the technology, geopolitical (convincing countries to join their side) and military sphere (building military capacity and military tech). We think both countries are now actively trying to sabotage each other using different methods (China with the help of Russia for example is trying to subvert western society, and the same is true for the US with regards to China's society, although harder). A sign of the heating up of Cold War II is the start of proxy wars in which China and the US are fighting against each other by supporting different sides (e.g. Ukraine war where China is supporting Russia, and the US is supporting Ukraine).

The third inevitable consequence is that each block will want to become independent: economically, financially, energy etc. The West will want to rebuild manufacturing capacity to re-gain independence in producing necessary goods. It will also want to reduce dependency on foreign investment both for the financing of the governments and of its companies. The same is true for China and countries aligned with China. China is particularly dependent on the West as a buyer of its manufactured goods. China is also quite dependent on other countries for agricultural goods to support its food needs.

How will the West and China react?

Everything we explained above is already happening or is bound to happen soon. But what really matters is how both the West and China are going to react and what choices they will be both make. We will run three hypotheses to explain the possible ways the next few years will play out.

#Hypothesis 1: The West de-couples from China

There are two reasons why this could happen. One is that the West, especially the US, wants to keep its own sphere of influence. One way to do this is to de-couple from China and keep only aligned countries in its trading/value system. The other one is that the China intensifies its mercantilist policies (subsidizing its industrial conglomerates), posing a threat to the West competitiveness in high value chain sectors (automobiles etc.) with the ultimate goal of de-industrializing the West even further and gaining global hegemony
The biggest dependency the West has on China is on manufactured goods. So, one of the key actions would be to put high trade barriers with China (tariffs, trade quotas, import bans). A complete de-coupling would entail a total breakdown of all the current supply chains, less efficiency, higher prices and inflation, and in the short term a shortage of advanced goods (electronics, chips, computers etc.). A second Trump administration could easily go in this direction and Europe could follow up.

Which companies would lose out the most?
The biggest losers would be Western multinationals with a business model that relies on China both as a producers and consumer. A perfect example is Apple: it completely relies on Chinese factories to produce iPhones, Macs etc. (90% of the assembly is done in China) and then sells to the US (35% of revenue), China (20% of revenue) and Europe (20% of revenue). In a nutshell it depends on China both as a producer and as a consumer.
Companies that rely on both critical resources (e.g. rare earth elements) and advanced manufacturing in China would also be hit hard (e.g. Chips companies like Qualcomm).

The other losers are going to be Western manufacturer that either depend on China as a producer (Nike, Adidas, Walmart) or as a consumer market (LVMH, Volkswagen, Starbucks, Boeing). These last two categories are going to be hit less than multinationals that depend on China both as a producer and consumer.

Who would gain the most?
Western manufactures that produce locally or in countries that are aligned with the West or that are at least neutral. They would benefit from an enormous spike in demand, higher prices and less competition. In our opinion this would benefit the most SMEs in Europe and Asian countries aligned with the West, particularly manufacturers that directly compete with China on middle value manufacturing chain (e.g. Italy). For European manufacturers this would be in effect a reversal of the misfortune of the past thirty years where they saw bankruptcies or decrease margins due to the outsourcing of manufacturing to China. Energy companies would also benefit, as shifting back manufacturing to the West will increase the overall energy demand. Same goes for natural resources companies that source critical materials in Western or aligned countries (e.g. Lynas Corporation, a major Australian producer of rare earth elements).

#Hypothesis 2: The west splits, China lures Europe under its sphere of influence

The US de-couples but Europe does not follow the same strategy, preferring to continue a positive relationship with China. This would effectively split the West and Europe would fall under China's sphere of influence, becoming dependent on Chinese consumers, technology, manufacturing and investments. This would deal a blow to the US power, the dollar dominance and the US goal of building an independent block.
Who would gain the most?
European multinational companies with high exposure to China and lower exposure to the US, particularly those dependent on China both as consumer and producer. In the short term the country who would benefit the most is Germany and its auto manufacturers (Volkswagen, Daimler, BMW) which are highly dependent on the Chinese market and have shifted their production there for the local consumers. However, these companies are now threatened by Chinese competition. Take Volkswagen as an example, it used to hold a xx% market share in China in 20xx, now it holds to stiff competition by China's EV manufacturers. It looks like it risks losing big parts of the European market to Chinese auto manufacturers. So, while in the short term this might benefit Germany, in the long term it's clear China strategy of upscaling its manufacturing on higher value chains puts Germany under stiff Chinese competition. On top of that it would completely lose the US market which still accounts for a large percentage of its revenue. Similarly, France could be pushed by its large conglomerates lobbying the government to have a closer relationship with China. To be more specific, LVMH, its largest fashion conglomerate depends on China for xx% of its global sales. It's in its interest to lobby the French government to continue a positive trade relationship with China. However, this could come at the cost of losing the US market.
The conclusion is: Europe will need to choose between keeping its advanced manufacturing integrated in the Western hemisphere but losing the large Chinese consumer market or integrating with China but entering in direct competition with its manufacturing powerhouses while losing the large US market. It's still not clear which direction Europe is going to take in the next few years

#Hypothesis 3: Hot war between the US and China

This is the riskiest, yet a possible turn of events. The current cold war, where the US and China fight though proxies (e.g. Russia and Ukraine), could turn into a hot war, where the two superpowers fight each other directly. Europe would find itself in the middle of the events, without having picked a side. However, Europe's dependency on the US for its defense would leave it extremely vulnerable to a Russian direct attack on NATO. Why? The US military would shift all its resources to Asia, leaving Europe alone in defending against Russia. Europe will need to turn its economy into a war economy, forcing companies and manufacturers to convert their production to support the defense efforts. The so-called creation of two blocks would be inevitable and abrupt, with severe negative economic consequences as alternative supply chains would not have been built yet.

Who would be the biggest beneficiary?

European and American defense contractors, Western heavy industry companies, chip design and manufacturing companies. All other types of manufacturing companies with local production who can easily convert their production would benefit as military subcontractors, yet they would lose consumer demand. The net effect would depend on how easily they can convert their production, and how exposed they were to foreign markets. Tech companies (especially cyber tech) would also benefit by working with governments as cyber is another domain where war is fought.

Who would be the biggest losers?

All companies that depend heavily on exports or large investments in countries that have not sided with the West. In fact, governments will put up trade restrictions on all enemy countries and adversaries. All their investments will also need to be written off, as foreign governments will appropriate of all their investments (e.g. exactly what happened to Western companies that were exporting and had investments in Russia). Other categories of companies that would be hard are the ones that cannot convert their production to the war effort as well as all the non-manufacturing companies that cannot sell their services to the military, as the loss of consumer demand would not be compensated by demand from the government.