The Friend Zone: Does a Breakup with China Mean a Tailwind for Japan, India, and Mexico?

Mirror, mirror, sleek and tall,
Who’s the friendliest shore of all?
Is it India with minds so bright,
Its large, tech-enabled population conveys its might.

Perhaps it’s Japan, with tech so fine,
Where robots dance in perfect time.
Or maybe Mexico, boasting ideal proximity,
Will cheap labor and logistics combine for ultimate simplicity?

China’s reign, now a tale of past,
Who’ll take the lead, who’ll hold fast?
In this global, shifting game,
Who’ll rise to prime offshoring fame?

Mirror, mirror, on the wall,
Reveal the friendliest shore of all!
In the dance of trade, let’s hope we find,
A future where all can thrive, intertwined.

As we continue to explore the investment thesis for emerging markets (EM) in what’s now become a three-part series (that, by the way, will likely stretch to four parts), we must contend, again, with the elephant in the room—China. In the context of “friendshoring” we must analyze both the perceived headwind on the Chinese economy and, more importantly, the tailwind for many ex-China markets. China is 34% of the EM portfolio by market cap and 43% of EM by GDP. The concentration of China in EM makes analyzing China’s risk uniquely important. However, the analysis goes beyond managing the 35% China weight in an EM portfolio. For thoughtful investors, the analysis is also crucial about the opportunities available to EM ex-China economies as the world aligns to the new reality of US friendshoring.

For the past two decades, China has greatly influenced the fortune of many EM economies. While EM economies are highly heterogeneous in their exports and economic developments, they are, nonetheless, highly dependent on the twin engines of global growth—the United States and China. China buys substantial amounts of 1) raw commodities from resource-rich regions like Latin America, Russia, Africa, and the Middle East, and 2) advanced electronic components from high-tech EM Asian exporters like South Korea and Taiwan.

The commodities trade has brought prosperity to resource-based EM economies and has driven China’s infrastructure advantage in roads, railways, seaports, and airports over other exporters. The energy consumption needed to power its 24/7 factories has made China one of the most important customers for energy producers. Through trade in semiconductors and other high-tech components, China has become the largest customer for Taiwan and South Korea, buying approximately 50% more than the United States does. Additionally, China has become one of the most important markets for Korean and Taiwanese consumer brands as millions of high-net-worth households have been minted on the back of entrepreneurship and high savings rates.

Once you understand the reality of the interdependency—that China isn’t just a competitor to its EM neighbors but more importantly a major buyer—analyzing the opportunities and risks for EM ex-China becomes significantly more complex. Friendshoring will not be as naïve as American buyers moving their factory orders from China back to South Korea, Taiwan, or even India, in a simple win–lose scenario. In this article, I will examine the following questions: Where will global manufacturing move to amidst US–China trade tension? What will trading be like in this friendshoring world? Who will be the winners, and is China the obvious loser?

The US–China Tension at the Core of Friendshoring

To start off, let’s be exceedingly clear. I don’t believe the US–China tension will go away regardless of who wins the next US presidency. Both parties have identified China as the favored boogeyman. For the foreseeable future, China as both an economic and security threat to America will be a permanent theme for US politicians. In many ways, this arc was inevitable. From Nixon inviting the then-impoverished communist China to join global trading, to communist China becoming, arguably, the most capitalist economy through trading with the United States, to the United States now aggressively advocating “friendshoring” and “trading away” from China. We have seen a familiar movie in the US–Japan relationship. This reminds me of a popular Chinese saying:

The #1 student in class can often have a healthy relationship with the #50; he might even tutor #50 as a volunteer. But the #1 and #2 are often bitter enemies.

As long as China wants to be an equal to the United States, and as long as the United States sees China challenging to be the “alpha,” the tension will not go away.

So, in this world of mutual agitation between the US–China, what are the opportunities for the rest of the EM countries? Who can provide a “friendly shore” and what are the implications for both EM and developed market (DM) countries?

Before China, There Was Japan, Taiwan, and South Korea… Who Comes Next?

Let me be blunt—don’t believe the election year slogan of “bringing manufacturing jobs back to America.” If Americans were dying for manufacturing jobs to put food on the table, we wouldn’t have a J-Powell-stumping 3% unemployment rate and record wage inflation. American firms aim to squeeze margins on manufacturing in EM countries to bring profits to American shareholders. They are not interested in bringing jobs back to a high-cost economy with a tight labor market. I don’t believe the US outsourcing will reverse. Of course, China, while still the best option for most manufacturing work, is not the only option. Indeed, prior to the mid-1990s, China wasn’t even a very good option. Before China was the world’s factory, things at Walmart were made in Japan, then Taiwan and Korea.

For a very long time, China, despite its massive population and its dirt-cheap labor, was not a good outsourcing option. It didn’t have a government that embraced free markets or exporting. However, as Japan, Taiwan, and South Korea developed and saved too much money, their laborers and managers wanted more, and those locations became too expensive for American firms looking for low-cost manufacturing. America needed a new manufacturing vendor with little pricing power and China, seeking to alleviate poverty, fit the bill perfectly. For more than two decades it was a happy marriage, with each party getting exactly what they needed.

To be sure, Japan, Taiwan, and South Korea all moved up the value chain to achieve higher per capita GDP and greater prosperity. They have formed an ecosystem around China, supplying it with high-tech components and precision equipment, rather than competing with China in manufacturing.

However, similar to Japan, Korea, and Taiwan, as China becomes wealthier and develops a substantive domestic consumption economy, it must push out more and more of the lower-end factory work to other low-income EM economies. I don’t think Beijing can stop this trend any more than Washington, DC, can force it to happen against market forces. Both can, however, do plenty to accelerate the transition. For now, a complete divorce is simply not possible. The world’s largest deficit-driven consumption economy needs the world’s largest factory eager to offer seller financing. (Note, China buying US debt is basically Chinese manufacturers lending Americans money to buy Chinese products.) A drama-filled, abusive, codependent relationship is what will have to suffice for now. In the meantime, the rest of the EM countries are looking for profit opportunities amidst the drama while avoiding collateral damage. No doubt, some will play the middle perfectly and extract benefits from both.

Will India Be the Next China?

Judging from the massive Indian bull market since the start of friendshoring, India is the crowd favorite as the next China. Much fanfare was given to Foxconn (the world’s largest high-tech contract manufacturer) when it invested $1.2B in India. Then, reports surfaced that only lower-end, older model iPhones can be manufactured in India due to quality problems. Additionally, labor practices, water, electricity, roads, and ports have all presented problems and added costs.

This, however, is not an indictment of India. Instead, it tells us that becoming the next China will take more than cheap labor.

To understand this better, it is important to recognize how the world factory transitioned from Japan to Taiwan, and later from Taiwan to China. American firms didn’t fire their Japanese contract manufacturers to place new orders with Taiwanese factories. Instead, it was the Japanese manufacturers who moved their factories to Taiwan to reduce costs and retain American business. Taiwan’s proximity to Japan and its cultural familiarity with the Japanese—due to Taiwan’s status as a Japanese colony prior to WWII—made it an attractive choice. In addition, the Taiwanese government welcomed Japanese companies with open arms and very favorable policies.

The situation was similar when Taiwanese manufacturers moved their factories to Mainland China. Proximity, a similar language and culture, and an eager Chinese government ready to grant land, subsidize electricity and water, and wave years of taxes—these were critical ingredients for the success of factory relocations. Most importantly, China was consistent and unwavering, until Xi Jing Ping, in backing factory operators in labor disputes. It didn’t earn the moniker of being the most pro-capitalist communist state without reason.

With that in mind, let’s swing our gaze back to India. Navigating the local Indian government hasn’t been easy for Foxconn, and labor issues continue to plague production. These “issues” are less about the quality of the Indian workforce and government, but more a statement about a mismatch in needs and compatibility. Up to this point, India has been the world’s solution for software development and call center outsourcing. Ports, roads, and reliable industrial water and electricity are not as necessary for that developmental path. India has committed to a non-manufacturing path of development. Its best laborers have a comparative advantage in English communication and software engineering; neither are particularly useful for a Foxconn or BYD factory floor job.

I argue the question isn’t whether India can be the next China. The question is whether India wants to be the next China. My bet is on India emerging via a completely different route than hardware manufacturing.

Other Friendly Shores

Taking lessons from Japan and Taiwan, Chinese manufacturers have already begun relocating some of their factories to lower-cost economies. America’s friendshoring initiative has further accelerated this effort, leading to more aggressive and creative solutions.

While casual observers might celebrate the success of US sanctions against China as Mexico surpassed China as the United States’ biggest trading partner, the truth is far more surprising. Clearly, Mexico has not learned to manufacture high-end electronics and build capacity and quality overnight. In truth, I don’t believe Mexico is a competitor for China in manufacturing. Higher tariffs and other frictions applied to Chinese exports are certainly not enough to make Mexican manufacturing competitive.

So, what has happened? If one looks carefully at the change in the mix of Chinese exports, they will find that China has recently begun exporting components instead of finished goods. While final assembly occurs at a Mexican factory operated by the Chinese, 90% of the manufacturing has already occurred inside China. With NAFTA, there is no closer or friendlier shore than Mexico. Essentially, Mexico, serving as an entrepot or a pass-through, can now offer products labeled as “Made in Mexico” but with Chinese pricing and quality.

Indeed, the exact same thing is occurring on another friendly shore: Japan. Chinese businesses have aggressively acquired Japanese factories. Japan, after nearly 35 years in deflation and with the recent cheap yen policy, have once again become a competitive manufacturer.

Coming Full Circle

As I mentioned before, a complete divorce between the United States and China is simply impossible in the near future. Rolling the clock back 35 years when global GDP stood at just $20 trillion, dethroning Japan as “the world’s factory” was a far easier feat for Taiwan and Korea. Back then, most factories cost $5M to set up and produced jeans and sneakers. Today, the world GDP stands at $110 trillion, with China accounting for 16% of total production. Chinese factories today are often billion-dollar high-tech facilities, sitting at the center of a complex supply-chain ecosystem. These advanced factories are managed and operated by top talents in process engineering, producing iPhones and other smart devices that require highly educated and skilled laborers. It will be a very different exercise, on a much slower timeline, to replace China’s manufacturing capacity.

However, some of the last-mile assembly work can be done elsewhere today. Higher-value intermediate products can still be produced in China and then exported to partner countries for final assembly in Chinese-operated factories. China continues to move up the value chain. Its export partner countries, Mexico, and Japan for starters, become entrepots standing between the United States and China. This allows US and Chinese firms to continue trading as usual despite the roadblocks created by Beijing and Washington, DC.

This tried-and-true method was successfully practiced when the Chinese Communist Party and Taiwan’s KMT were still sworn enemies (funny how things have changed). Hong Kong was the entrepot, the free port that stood in between to facilitate trading. All during that time, Mainland China and Taiwan were secretly each other’s largest trading partner. This brought tremendous job and wealth creation for Hong Kong, catapulting it to one of the richest economies in the world on a per capita basis.

China transitioning last-mile manufacturing to two of America’s friendliest shores will drive tremendous wealth creation for Mexico and Japan. Mexico, directly connected to the United States and benefitting from NAFTA, is literally America’s Hong Kong. Its proximity to California and Texas, which have substantial Chinese immigrant populations and strong Chinese communities, allows Chinese factory executives to settle their families in the United States while working in Mexico.

Japan is the United States’ most reliable and important ally in the Pacific theater. And now with cheap yen, Japanese labor is again globally competitive. Considering their renowned quality and work ethic, Japanese labor could be the best bargain for China on the table. Furthermore, the proximity to China and the Chinese preference for Japan as a destination country make executive relocation easy.

When it is all said and done, politicians in Washington, DC, and Beijing can continue to trade barbs and appear powerful to their constituents. American buyers and Chinese suppliers can continue to trade printed dollars for manufactured goods, and both will profit. Those who stand in between as pass-through will benefit handsomely for their trouble—gaining factories, jobs, capital, and infrastructure. It is comforting to know that, as always, the invisible hand of commerce and mutual profits guides us to win-win-win in spite of our zero-sum win–lose politics.

Disclosures

This article contains opinions subject to change without prior notice. This is not a recommendation to purchase or sell any securities discussed herein. The securities identified and described do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable. This article was written by Jason Hsu, a portfolio manager at Rayliant Global Advisors, as an opinion piece and the opinions herein are those of Jason and not Rayliant Global Advisors.