Written by: Brendan Ahern , Chief Investment Officer at KraneShares On a recent visit to China, I met with a wide variety of financial institutions to discuss their views on the current economic relationship between the United States and China. Interestingly, their sentiment toward the U.S. was still extremely positive. Many compared our countries to a married couple currently having a disagreement. No one doubted the fundamental value of the relationship, but they were uneasy about the abrupt change in U.S. negotiation tactics. President Trump’s “Art of the Deal” prescribes an extreme starting position that is eventually worked out through a levelheaded compromise. The near term market volatility we have seen recently stems from domestic Chinese investors who take their leader’s words as definitive policy and apply the same logic to the U.S. president. For long-term international investors this means Chinese stocks with strong fundamentals are currently trading at a huge discount to the S&P 500, providing what may be an excellent entry point to the Chinese market.While trade tensions have created uncertainty, we believe China’s economy is more resilient than what the headlines portray. Three macro trends suggest that tariffs could have a relatively muted long-term impact on economic fundamentals in China: 1) economic growth is increasingly fueled by demand from domestic consumers, 2) Chinese policymakers began weaning the economy off of foreign demand through monetary policy long before any talk of tariffs, and 3) Chinese firms are likely to maintain, or even augment, their present competitive advantages if trade tensions escalate.In recent years, China has made great strides in transitioning from a manufacturing and export-oriented economy to a consumer and services-oriented economy. In 2006 exports represented 36% of China’s GDP, by 2017 they were only 19.7%1. Looking at the potential impact of tariffs on China’s economy, only 19% of China’s 2017 exports went to the U.S.2 representing only around 3.6% of its total economy. Over the same period of time the strong performance of China’s consumer-oriented companies, such as Alibaba and Tencent, underscores how quickly China’s economy has evolved toward domestic consumption.Related: The Portfolio Implications of Trade Disputes China’s economic ministers have long viewed the domestic consumer as the key to sustainable economic growth. In recent years this has been most evident in China’s tight monetary policy implemented through credit reduction. China has actively curtailed the longstanding practice of large Chinese conglomerates issuing local debt then using it to buy predominantly U.S. dollar denominated foreign assets. This practice drove down the value of the renminbi (RMB) and the purchasing power of the Chinese consumer. In response, the government implemented capital controls to slow down these outflows. Additionally, the government has initiated a deleveraging campaign, mostly targeting so-called “shadow banking.” As a result of these policies, the RMB has remained stable enough to keep the Chinese consumer consistently empowered and optimistic. While trade war pressure on the RMB could potentially jeopardize these tightening policies, the People’s Bank of China is still in a good position to find the right balance between quantitative easing and reform.In a recent research report, leading Chinese investment bank, China International Capital Corporation (CICC) notes that some easing will be necessary to offset trade pressures though in the best-case scenario it will be accompanied by policy reforms3 to avoid a permanent slide in the currency and a regression toward the “old” Chinese economy. In 2012, the European Central Bank (ECB) began a similar aggressive quantitative easing program in response to the debt crisis. However unlike China, whose strong central government can easily implement policy, the ECB was unable to fully back up the program with cohesive austerity policies across all of its member states.Furthermore, China is still the single largest owner of US treasuries, which makes a full-fledged currency war unlikely. Countries such as Turkey, Argentina, and Brazil have been negatively impacted by a rising dollar because they run current account deficits with dollar denominated debt. China is in the opposite position because it benefits from appreciation in its substantial U.S. dollar holdings. Additionally, most credit growth in China comes from corporations and not from the central government. Thus, Chinese policymakers are well positioned to ensure that companies posing systematic risks are provided support without impacting the government’s credit profile.Finally, the competitive advantages of Chinese firms, even those whose revenues are heavily export driven, are likely to survive trade friction. Chinese firms usually provide the most labor-intensive components to the U.S. and other countries.4 It is unlikely that any level of protectionism will cut out this competitive advantage in auto manufacturing and many other similarly export-dependent industries. Retaliatory tariffs, which have already been imposed by the Chinese government on some products, may give Chinese firms that see intense competition from multinationals a significant price advantage at home. This is especially the case for local players in software, automobiles, medical equipment, and agriculture5.Related: Will Trade Skirmishes End the Economic Cycle? With regard to China’s equity markets, the primary driver of the volatility of mainland Chinese stocks this year has been sentiment, not fundamentals. Macroeconomic stability and resilience aside, valuations of Chinese stocks in the Shanghai Composite Index have been driven to near all-time lows compared to those in the S&P 500 by measures of both price to earnings and price to book ratios6. Over the last decade the average price to earnings multiple for stocks included in the Shanghai Composite Index has been around 16, while today it stands at 13.5. In a research report titled “Scenario Analysis of Impacts from U.S.-China trade Friction” CICC researchers conclude that the impact of a decline in exports to the U.S. has already been priced into the market and that buying opportunities are emerging as a result.This deep undervaluation is partially due to Chinese individual investors reacting to headlines coming out of the United States. Unlike in the U.S., where institutional investors dominate the market, retail investors own the vast majority of the mainland market. Across the board, individuals are more reactive to sentiment than institutions. Individual investors in China are accustomed to a political environment in which their president’s words are taken as policy. However, ownership of China’s stock market is steadily being institutionalized. This undervaluation is occurring just as leading global index provider MSCI is beginning the second inclusion of mainland stocks in their emerging markets index, which is tracked by $1.9 trillion worth of actively and passively managed assets. Also, this year foreign asset managers were permitted, for the first time, to launch mutual funds and hedge funds in China without a local partner. Because recent volatility is driven by sentiment and not fundamentals, we believe there is currently tremendous opportunity in the deep discounts offered in the Chinese equity market.Tariffs on Chinese exports to the United States do not negate the strong fundamentals of Chinese stocks and the new Chinese economy. As import tariffs are, first and foremost, a bargaining chip, it is likely that the U.S. will ease the pressure once underlying disputes are resolved. At that point, the marriage between the world’s two largest economies can return to normal, hopefully without friction or long-term damage, creating value for investors on both sides of the Pacific. We believe that trade tensions have already been priced into the market at an extreme level. In addition, my experience in China suggests that local institutional investors still appreciate the long-term value of the U.S.-China relationship. As such, present tensions may provide an excellent entry point into the Chinese market for long term investors.