Here's How China Can Crush US Tech Firms If Trade War Escalates

President Trump rattled stocks on Wednesday after the Commerce Department rolled out its list of Chinese products, representing $200 billion in imports, that could soon face 10% tariffs Tuesday night - the latest sign that the escalating trade war between the US and its largest economic rival is still heating up. And, echoing recent comments from Morgan Stanley, on Wednesday morning, Bloomberg pointed out that China could soon opt to "trip up" US tech firms operating in the region, something that MS analysts say could have serious repercussions for US equities which have yet to be adequately priced in by the market, and which earned the tech sector a downgrade to underweight.

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Since China imports far fewer goods from the US than the US imports from China, the country has threatened to embrace other tactics as part of its retaliation, like imposing new taxes or adding regulation on US companies, slowing deal approvals, or encouraging citizens to boycott American products, the WSJ reported today.

Some companies that export goods to China have already reported unexplained holdups at customs or in other areas. And as Bloomberg reported Wednesday, US tech companies - which have led US the US equity market all year as the bulk of the S&P 500's gains have been on the back of a handful of megacap tech stocks - are particularly vulnerable to the Communist Party's wrath. Which is one reason why Morgan Stanley recently recommended that its clients stay long volatility into the summer. As Michael Zezas, Chief US Public Policy & Municipal Strategist at Morgan Stanley wrote earlier this month: "In equities, our team thinks that US tech is vulnerable as a sector where pricing has been insensitive to trade risks so far."  

As a reminder, it is tech stocks that have been the pillar upon which the market's 2018 gains were erected, with just the 5 biggest stocks responsible for nearly all the S&P's upside in 2018.

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Out of all US tech companies, Apple is perhaps most vulnerable to China's retaliation. While President Trump has reportedly promised Apple CEO Tim Cook that iPhones will be spared from the Trump administration's tariffs it's likely only a matter of time before Xi Jinping becomes frustrated with Tim Cook's ineffectual attempts to act as the tech community's "chief diplomat" and decides to crack down on the world's largest company. 

Apple is the master of global electronics supply chains. While the company is based in the U.S., China has arguably become its most important market. The vast majority of Apple products manufactured across China, and the company generated about 20 percent of its revenue there during its most-recent fiscal year.

Since launching bigger-screened iPhones in China and striking expansive wireless carrier partnerships with China Mobile and others, Apple has thrived there. The company has increasingly configured some of its hardware and software for the region - at a level beyond any customization for other markets. It also released a gold iPhone to appeal to Chinese consumers, added mobile-payment support for some of the country’s transit systems, and developed messaging features that mimic popular functions of local services like WeChat.

The company has also followed local laws, agreeing to relocate data storage for its iCloud services to state-affiliated servers in China. Tim Cook, Apple’s chief executive officer, also visits China regularly for public and private events.

But while the crackdown on Apple remains one eventuality, the Chinese government has a more direct route: hitting M&A deals, like scuttling Qualcomm's planned takeover of NXP. The US chipmaker has little more than a week left to close the deal before its agreement with NXP expires.

That chip deal is one of the most prominent hostages of the brewing trade war between the U.S. and China. Qualcomm promised investors that the transaction would be closed by the end of 2017. NXP has given Qualcomm until July 25 to close the deal or their agreement will expire.

Qualcomm already won clearance through the investigation phase of China’s approval process, people familiar with the matter told Bloomberg earlier this year. The final announcement, though, may be held up amid the high-level standoff over broader trade issues and the fate of Chinese telecom equipment company ZTE Corp.

The complexity of politically infused, cross-border acquisition approvals is relatively minor compared to the global electronics supply chain, which binds China and the U.S. and creates domestic tensions for both countries. An Intel Corp. processor made in Oregon or Arizona will often head to Chengdu where it’s packaged for final installation into a computer. That computer can then be assembled for a U.S. company such as HP Inc. by a Chinese subcontractor and shipped to the U.S. for sale. It’s unclear which parts of this process would be affected by U.S.-China tariffs.

And here is why semis are especially vulnerable: chipmakers and other tech companies derive a larger percentage of their sales from China than any other US industry.

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According to Deutsche Bank calculations, US-based companies have a trade surplus of $20 billion with China if US corporate revenues are factored in. Given this vulnerability, and with the US showing no signs of backing down, the question of whether Xi and the Communist Party will go after US tech giants that they once sought to court is no longer a question of "if", but a question of "when."

And if a true tech selloff gets rolling - one that even corporations couldn't stop by stepping in and buying back their stocks...

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... it's impossible to say where it will stop.