Stock Market & Economic Commentary - May 2025

Economic Update

The rise and rise of China

In January, Chinese company DeepSeek stunned financial markets with the release of its generative artificial intelligence model R1. It matched the efficacy of market-leading US firm OpenAI’s most advanced models but was produced at a fraction of the cost.

The DeepSeek announcement is one in a series of recent developments that mark a new stage in China’s economic evolution.

Over the last four decades, economic reform and China’s entry into the global trading system have transformed China’s economy and raised it from low to upper-middle-income status. There has been a sea change in the research and development capabilities of China’s universities and domestic companies, with Chinese businesses now on par with world leaders in several sectors.

From being the workshop of the world, known for manufacturing basic goods at low cost, China has evolved into a producer of technologically complex goods, from computers and telecommunications equipment to electric vehicles, machine tools, and drones. Western incumbents in high-value-added sectors are facing increasing competition from China.

Take EV batteries. Many modern ones are based on Lithium Iron Phosphate (LFP) technology, which originated in the US in the nineties but was largely ignored by manufacturers, given meagre short-term returns and doubts over its effectiveness. It was Chinese battery companies, especially CATL, that directed research towards this technology and made transformative refinements. CATL now accounts for around 40% of the global market for EV batteries. Just last month, CATL announced its Shenxing 2 LFP battery that delivers a range of 520km with just five minutes of charge.

UK reviewers have been impressed with the latest crop of Chinese cars. Autocar has said, “Chinese models are up there with the best in the business” with the Xpend G6 model described as a “credible Tesla Model Y rival, with an upmarket interior, decent ride quality and a price advantage over the American EV”. Commenting on the market for small electric cars, Top Gear concluded, “When you dig into what the [Chinese-made] MG4 does for the money, it’s probably the only car in the class to recommend”.

Chinese companies have become world leaders in the markets for batteries and solar panels. But how innovative are they across other advanced industries?

To answer this question, the US Information Technology and Information Foundation (ITIF) conducted a 20-month investigation of Chinese industrial capabilities in ten advanced technology sectors, from robotics and chemicals to biopharmaceuticals and nuclear power. Their study, published last September, found that Chinese firms are leading innovation in nuclear power and EVs/batteries. In four other sectors – robotics, quantum computing, AI, and display technology – China is not far behind the global leaders and is making rapid progress. The ITIF assesses that at this pace of development, China is likely to equal or surpass the Western leaders in less than a decade.

Patents tell a similar story. An ITIF study shows that, in 2010, Chinese firms accounted for less than 1% of patents granted by the US Patent and Trademark Office. By 2020, that had risen to 7%, with China granted the third-highest number of patents behind the US and Japan. The US, nonetheless, still leads in turning ideas into profit. World Bank data show that in 2023, China’s intellectual property licensing receipts were less than a tenth of US levels.

Nonetheless, this is a remarkable transformation driven by a number of factors – rapid growth, private and public investment, and most of all, government policy.

Through its “Made in China” initiative, the government has poured money into 10 key industries, with the aim of making them world-leading producers of high-end equipment and goods. While some critics have questioned the efficiency of the initiative, it has significantly boosted government spending on R&D.

According to the OECD, China’s expenditure on R&D was 72% of America’s in 2013. By 2023, it had grown to 96% and was rising at just under 9% every year, a significantly faster pace than the US.

Government subsidies and tax credits, along with a general rise in corporate profitability, have also supported private sector investment in research. The European Commission compiles an annual list of the top 2000 businesses investing in R&D. In 2013, only 93 of these firms were located in China, compared to 658 in the US. By 2024, the number of Chinese firms in the list had risen more than fivefold to 524, compared to 681 in the US and 322 in the EU.

China’s emergence as a global technology leader poses a threat to America’s domination in the field. The DeepSeek announcement wiped nearly a trillion dollars from the market value of American tech majors. US president Donald Trump said it was a “wake-up call” for US companies.

Unlike earlier competitors in the field of technology, such as Japan or South Korea, in China the West faces a strategic rival. Yet the relationship is complex and involves both interdependence and rivalry. As the EU puts it, China is a partner for cooperation, an economic competitor, and a systemic rival.

The US, like the EU, sees China as a systemic competitor. But the two great Western blocs are responding very differently.

The US has gone in the direction of economic “decoupling”, seeking to reduce economic and technological ties with China, especially in strategic sectors, including semiconductors, critical minerals, and advanced technologies. The EU has explicitly rejected decoupling and instead pursues what it calls “de-risking”. It aims to reduce dependencies in key sectors, increase supply chain resilience, and protect key technologies without severing economic ties. The UK has taken a similar approach, one that led the US chief trade adviser, Peter Navarro, to brand Britain a ‘compliant servant of communist China.’

The rise of China is causing a reset in trade and economic cooperation among its Western partners. What, precisely, that means is open to a wide variety of interpretations, but investment opportunities abound. According to the Financial Times, Beijing sees the current moment in US foreign policy as a golden chance to win friends and influence people around the world.

The Chinese culture is vastly different from the Western world, but with a population four times greater than North America, and with US stock market dominance beginning to fade, could China eventually, perhaps soon, rival the USA as a viable alternative for investors seeking above-average returns?

Stock Markets

“The only way to make sense out of change is to plunge into it, move with it, and join the dance.” – Alan Watts (January 1915 – November 1973), British and American writer and philosophical speaker

The story of the Titanic has captivated people’s imagination ever since it sank on 15 April 1912. The Titanic was a magnificent ship that set new standards for luxury cruising and design, including groundbreaking advances for safety. The public was captivated by the vessel, and due to the ensuing publicity, it became generally accepted wisdom that the ship was “unsinkable”. Historians speculate that the captain was heavily influenced by public opinion, leading to the disastrous order to sail at high speed into an area where iceberg warnings had been issued. After colliding with an iceberg, the laws of physics overcame the accepted wisdom, leading to the ship sinking and the loss of over 1,500 souls.

Donald Trump was elected for a second term on 5th November 2024. Stock markets cheered his appointment, reminiscent of the crowds who gathered in Southampton in 1912 to wave off the Titanic. In both cases, the exceptional vessel – the Titanic then, and the US state now – was led by a trusted captain promising to deliver glory, supported by enthusiastic public confidence. Nevertheless, both ran into significant difficulties in short order, due to poor and unnecessarily aggressive decisions, likely driven by self-serving bias. Whereas the Titanic sank, the political and economic equivalent could be the potential end of US exceptionalism – something investors should consider carefully.

The actions of Elon Musk are also worthy of mention to illustrate the potential disconnect between the US administration and the population they serve. Some readers will remember a talk given by Gerald Ratner in April 1991, who was then CEO of the Ratner Group, a high street jewellery retailer. At the time, Ratner’s turnover was growing while the high street was generally struggling. His success was due to a focus on inexpensive jewellery, silverware and glassware, purchased by the working classes seeking upward mobility. During a speech to the Institute of Directors, Gerald joked that their products were ‘total crap’ and likely to be outlasted by a Marks & Spencer prawn sandwich. Following the speech, his customers deserted the stores, with 300 closing before the group was restructured in 1994.

Although bad publicity is never helpful, Ratner’s customers felt betrayed by the brand, and trust could not be restored. Tesla has many customers who are passionate about the environment and Elon Musk should not be surprised therefore that his close association with the removal of the US from the Paris climate accord, the “drill baby drill” energy policy and his gleeful chainsaw antics of sacking “useless” government workers was not well received by his customers. Tesla sales have plummeted, and only time will tell if customers return, or if Musk is cast aside to repair the damage as happened to Gerald Ratner.

The apparent lack of empathy from the US administration toward its voters, allies, and the world has elevated political risk. The US imports around 13.5% of global trade and only exports 8.5%, leading to a trade deficit with the world of approximately $1.5 trillion. These statistics are at the heart of Donald Trump’s policies on global trade as he believes the US is being “ripped off”.

Donald Trump wishes to use the cash raised from tariffs to reduce debt and fund tax cuts. However, if trading partners reciprocate, the effect is neutralised, leading to a loss/loss outcome as global trade simply reduces. Although the strategy has merit, it will require masterful negotiation tactics, and so far, the approach has been aggressive, chaotic, and ineffective. This has resulted in confusion, various capitulations (particularly with China), and damage to the US global brand.

Of course, in the world of Trump everything can change in the blink of an eye and in a major blow to his core economic policy, the US Court of International Trade ruled last Wednesday that Congress alone had exclusive authority to regulate commerce with other countries, and that presidential powers to safeguard the economy did not overrule that. The ruling invalidates most of Trump’s tariffs with immediate effect, and the administration has been given 10 days to dismantle the regime.

But in this rapidly evolving landscape, the latest development is unlikely to be the last twist in the tale. The White House said it would appeal and claimed it was ‘not for unelected judges to decide how to properly address a national emergency’.

The world will once again be watching closely as the US legal system seeks to hold its highest office to account.

“Taco”

After the sell-off following the announcement of sweeping US tariffs in early April, stock markets have rallied on hopes that the US will strike trade deals. “Taco” as it has become known, is the latest stock market trade. The term encapsulates the notion that “Trump Always Chickens Out”, particularly in relation to his beloved trade taxes, and that equities will rise in response.

The US and UK settled on a framework agreement on trade last month, and the US and China have agreed to cut tariff rates and open trade negotiations. Press reports suggest that other outline agreements may be in the offing, although the recent announcement that goods from Europe will be subject to tariffs of 50% seems to suggest otherwise. But once again, “Taco” has prevailed with euro zone tariffs now delayed until 9 July.

US equities have rallied almost 20% since Trump announced a 90-day pause on tariffs, more than making up losses on the initial tariff announcements, although still below the peak of three months ago.

Investors are daring to hope that the worst news on tariffs may be past, but even if it is, US tariffs are likely to settle at levels far in excess of those at the start of the year. JP Morgan estimates that, with the rollback of tariffs on China, the average US tariff on imports has fallen from about 28% to 15%, but even this lower rate is six times higher than January’s tariff level of 2.5%.

Forecasts for global growth have fallen in response to the news on tariffs, with the US seeing an especially marked downgrade, but at least for now, greater optimism on trade has quelled fears of the US falling into recession this year.

Diversification, not concentration, is your friend

The US stock market has historically enjoyed an average valuation premium compared to other global markets of around 15% due to the innovative nature of the US economy and the enhanced liquidity courtesy of the dollar’s status as the global reserve currency. This premium reduced to near zero around the 2008/9 global financial crisis and steadily rose to a high point of approximately 35% in January this year.

For investors all over the world, US stocks and bonds have been a comfort for years. US assets occupy a far larger slice of the average investor’s portfolio than the relative size of its economy, in the order of 60% of global stock indices, despite representing only 4% of the global population and around 11% of global trade.

As the US withdraws from free trade, the remainder of the world is seeking closer trading relationships to replace the potential reduction in US demand. A level of US isolation could occur, and market forces are more likely to cause dollar weakness going forward as the reserve currency status diminishes. Given the reduced confidence in the US and the expected continued push to reduce its trade deficit, the likelihood of the US market premium falling is high.

The prospect of US isolation and protectionism will reduce economic growth expectations but also increase inflation risks. This is often described as “stagflation” – where real growth is low, but nominal growth is higher – and reflects the experience of the 1970s and 1980s. During these periods, the inflationary protection of real assets such as equities, commodities, and infrastructure mitigated risk far more effectively than bonds, which struggled due to high issuance from indebted governments and inflation risks. The ability of bond markets to protect investors cannot be relied upon within the new emerging cycle.

Governments have an incentive to keep inflation levels in the 3% – 4% range to reduce the real value of the debt burden. Cash and fixed-term deposits will continue to lose value in real terms. Fixed interest investors are likely to demand a higher return, putting capital values on longer duration bonds under pressure.

In summary, the US has enjoyed exceptional market valuations built up since 2008/9, which are high relative to other markets and long-term averages. Stock markets in the UK, Europe, Japan, and Asia provide better value than the US, particularly the Magnificent Seven tech stocks. The recent trend of US stock market underperformance looks set to continue throughout the remainder of this administration.

Diversification by geographical region and sector with lower exposure to the US is, we believe, the key to securing reasonable, inflation-beating returns going forward. Opportunities to achieve decent long-term returns are plentiful. On this basis, we remain confident in the current positioning of the Clarion Funds.

Please click here for further information about the Clarion Portfolio funds and our approach to factor investing.

As always, we thank you for your continued support and we look forward to updating you regularly throughout 2025. Please get in touch if you have any questions.

Keith W Thompson

Clarion Group Chairman

May 2025

Risk Warnings

Any investment performance figures referred to relate to past performance which is not a reliable indicator of future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments, and the income arising from them, can go down as well as up and is not guaranteed, which means that you may not get back what you invested. Unless indicated otherwise, performance figures are stated in British Pounds. Where performance figures are stated in other currencies, changes in exchange rates may also cause an investment to fluctuate in value.

The content of this article does not constitute financial advice and you may wish to seek professional advice based on your individual circumstances before making any financial decisions.

Stock Market & Economic Commentary – May 2025