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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Bi-Weekly Geopolitical Report. I'm Phil Adler. Tariffs may be the most noticeable, but they're not the only strategy in the economic conflict between The United States and China. Confluence Associate Market Strategist Thomas Wash joins us today to discuss how export controls are amplifying this conflict and the message for investors. Now, Thomas, you see export controls as an escalation from tariffs.
Phil Adler:Why?
Thomas Wash:Well, export controls represent a significant escalation beyond tariffs because they shift the conflict from economic pressure to strategic containment. While tariffs are blunt instruments aimed at reshaping trade imbalances, export controls like those targeting semiconductors are more like precision tools designed to cripple China's technological advancement. You know, the broader trade war was about incentivizing China to reform its economic model. But export controls reveal a more confrontational goal actively thwarting China's rise in critical sectors. By restricting access to advanced chip making technology, The US isn't just seeking leverage, it's attempting to freeze China's progress in an industry central to military, AI, and geopolitical power.
Thomas Wash:This isn't just a trade dispute anymore. It's a race for technological supremacy, and export controls are the new battlefield.
Phil Adler:So the purpose of export controls differs a bit from the purpose of tariffs?
Thomas Wash:Yeah. I I would say so. Tariffs are primarily defensive, meaning that they're designed to shield domestic industries from foreign competition by making imported goods more expensive. You know, this encourages consumers and businesses to buy locally produced alternatives supporting domestic jobs and production. Export controls, by contrast, are offensive.
Thomas Wash:They restrict the sale of critical goods to specific foreign entities or countries. The goal is to undermine a competitor's capabilities.
Phil Adler:In your report, Thomas, you looked into two key industries affected by export controls today. They are chip technology and rare earths. Let's begin with chip technology. Who who is winning this competition right now?
Thomas Wash:Well, The US maintains a dominant advantage in the tech space, leveraging cutting edge technology and top tier equipment to produce best in class chips. Its unparalleled ecosystem of entrepreneurship and academic research further solidifies this leadership. While China has made strides in narrowing the gap, its progress has been hindered by inefficiencies, corruptions, and a lack of transparency in its investment landscape, factors that have rendered its catch up efforts slower and far more costly.
Phil Adler:Is China catching up?
Thomas Wash:By some estimates, The US currently maintains about a three to five year technological lead over China. While China has made significant stride in recent years, it still struggles to replace key technologies critical to closing this gap. As a result, Beijing remains heavily dependent on The US and its allies for advanced semiconductor capabilities, limiting its ability to erode Washington's competitive advantage.
Phil Adler:What strategies is China using to try to narrow the gap?
Thomas Wash:Well, China's using multiple strategies to close its technological gap, including leveraging foreign partnerships for knowledge transfers, engaging in corporate espionage to acquire intellectual property, and innovating with less advanced hardware. For example, DeepSeek developed a competitive AI model despite relying on less sophisticated chips.
Phil Adler:Talking about the emergence of DeepSeek, which got so much attention, is that a sign that China might eventually win this competition?
Thomas Wash:The emergence of DeepSeek and the attention it garnered certainly highlights China's growing capabilities in AI development, but it doesn't necessarily guarantee that China will ultimately win the AI competition. While DeepSeek made a strong initial impression, particularly with its processing speed, US based models have since caught up and even surpassed some of its benchmarks. The AI race is highly dynamic with rapid advancements happening continuously across the globe. Although DeepSeek is progressing at an impressive pace, recent evaluation suggests it still lags slightly behind the current leading models.
Phil Adler:Looking, at the technology race between the two countries, is Taiwan the linchpin in the face off over chip technology?
Thomas Wash:I would say Taiwan is indeed a linchpin in the global face off over chip technology, primarily due to the presence of Taiwan Semiconductor Manufacturing Company or TSMC for short. It is the world's most advanced semiconductor foundry in the world. TSMC supplies cutting edge chips to major tech companies worldwide, making it a critical player in the industry. If China were to take control of Taiwan, Beijing can gain access to TSMC's proprietary technology and intellectual property, which would dramatically boost China's semiconductor capabilities. This could allow China to accelerate its development of next generation chips, potentially shifting the balance of power in the global tech landscape.
Phil Adler:Let's turn to rare earth elements now. China has amped up trade restrictions on these materials, which are needed for a variety of crucial initiatives in the defense industry and advanced technologies. First, how rare are rare earths?
Thomas Wash:Actually, the term rare earths is kind of funny because they're not really that rare at all. You know, these 17 metals are actually more common in Earth's crust than gold. The name's really a misnomer. But here's what's interesting. While they're plentiful overall, there are six specific rare earth elements that are absolutely crucial for making semiconductors.
Thomas Wash:What makes them so special is their unique properties that we just can't easily replicate with other materials when it comes to producing advanced chips.
Phil Adler:Why does China hold such dominance in the production of these rare earths?
Thomas Wash:They've got a couple of major advantages. First off, they're sitting on a huge chunk of the world's reserves, something like 37% with a lot of it concentrated in one place called the Bayan Obel. But it's not just about what they have in the ground. Their government policies like subsidies plus less restrictive environmental rules and lower labor costs have made their production way cheaper. That's allowed them to really undercut everyone else and grab a massive share of the market.
Thomas Wash:Something like 75% of production in almost all of the processing.
Phil Adler:Well, how would you describe the recently announced restrictions by China on rare earth materials? Are they meant to be an interim step toward a potential complete shutdown?
Thomas Wash:China's decision to impose rare earth export restrictions serves as a strategic reminder to Washington of its capacity to disrupt US technological advancement. While most firms will avoid immediate disruption as the measures exempt existing contracts, the move will compel American companies to urgently diversify their supply chains. This calculated pressure forces The US to confront its dependence on Chinese rare earths while buying Beijing geopolitical leverage.
Phil Adler:If we lose access to Chinese production, can The United States somehow make up the difference elsewhere?
Thomas Wash:You know, not immediately. The US will initially need to rely on its existing stockpiles. The primary challenge is that establishing new rare earth production takes years. For instance, a planned rare earth mine in Wyoming isn't expected to open until 2029. In the meantime, The US is pursuing partnerships with other nations to bridge the gap.
Thomas Wash:One such effort involves negotiating with the Democratic Republic Of Congo, where The US is exchanging security assistance for critical mineral access. Similarly, The US is discussing a joint agreement with Ukraine linking mineral exports to repayment for wartime aid.
Phil Adler:Well, there always seem to be winners as well as losers in any economic conflict even though overall economic growth in both countries appears to be threatened in a trade war. Who are potential winners from these trade restrictions?
Thomas Wash:Oh, here's the interesting thing about this competition. While it might cause some short term headaches for the chip industry, it could also work out well for tech companies on both sides in the long run. Chinese firms are already seeing benefits with their stock prices getting a nice boost from government backed supply chains. And on the American side, well, new policies designed to make key minerals more affordable could really pay off down the road, giving US companies a stronger position to compete.
Phil Adler:Thomas, we've discussed how tariffs and export controls are both steps up the ladder of economic conflict. What might come next?
Thomas Wash:Right now, these measures are targeting first rung of the escalation ladder, basically trade and physical goods. That tells us this is serious, but still relatively mild compared to what could come next. Here's where it gets interesting with tech. We might actually skip over the intermediate steps like restricting service trade and jump straight to limiting capital flows. You know, picture this.
Thomas Wash:Governments could block investors from buying each other's tech stocks. That might push more companies to stay private rather than go public, adding a whole new layer of secrecy to the tech arms race.
Phil Adler:Thomas, finally, as we wrap up, could you briefly recap adjustments in model portfolios made by Confluence in response to this current environment.
Thomas Wash:The near term outlook for equities in both markets faces significant uncertainty. Export controls and new tariffs are expected to pressure earnings growth, creating dual challenges for companies, constrained supply chains, and restricted access to key export markets. Given these headwinds, we've adopted an underweight position on US equities in our portfolio strategy.
Phil Adler:Thank you, Thomas. The title of this week's report is Export Controls: Another Battle in the US China Trade War. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice, and this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stole.
Phil Adler:I'm Phil Adler.