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President Donald Trump speaks after announcing and initial deal with China while meeting the special Envoy and Vice Premier of the People’s Republic of China Liu He at the Oval Office of the White House in Washington, DC on October 11, 2019.

Nicholas Kamm | AFP | Getty Images

After a partial trade deal, what’s next?

The next move could be a ratcheting up of the attacks on Chinese listed companies in the United States.

Today’s rally clearly indicates that the market is happy for the moment with just a partial deal, though the Dow gave up 200 of its 500 point gain in the final half hour as markets realized there was a cessation of tariff hikes but no clear timeline for removal of the existing tariffs.

UBS’s Art Cashin is doubtful that the good feelings will last. “I don’t think this gets us to Christmas,” he told me. “I think it could be a temporary truce that wouldn’t last very long.”

This partial deal, Cashin said, does not change the longer-term narrative of lower growth for 2020, nor does it end the trade wars.

Others agree. “The trade war is one channel. The U.S. will still press forward and confront China in other areas,” Marc Chandler, chief market strategist at Bannockburn Global Forex, told me. “The cold war will not go away just because there is a truce in the tariff war.”

“Tariffs have been the tip of the spear in Trump’s trade wars,” Chris Krueger, Senior Policy Analyst at Cowen said in a recent note to clients. “The next fronts – capital flows, [more] export controls, supply chain duress, industrial policy – are the global plumbing of the real economy.”

The impact of this next round in the trade wars, Krueger says, “can produce exogenous shocks to the global system that can dwarf the tariffs.”

China’s accounting issues

Another issue that will likely be part of the U.S. toolbag to continue to pressure China: accounting.

In June, Sen. Marco Rubio and several other senators introduced a bill to delist firms that are out of compliance with U.S. regulators for a period of three years, with a particular emphasis on China.

The reason: Chinese firms are forbidden from sharing information from their auditors with U.S. regulators because the Chinese government will not allow them to do so.

“Our capital markets are the deepest and the most liquid in the world, but we have high standards for exposure and transparency in order to protect investors from fraud,” Senator Rubio said on CNBC this week. “And it is very simple: if Chinese companies want access to U.S. capital markets, they should follow our laws the way American companies have to follow their laws over there.”

Chinese firms do release their audit reports to the public for U.S. public companies. However, Torrie Miller Matous, director of external affairs for the Public Company Accounting Oversight Board, said the issue is what they can see behind those audit reports.  “Because of the positions taken by Chinese authorities, we are precluded from inspecting the audit work behind the publicly-issued audit reports,” she said.

All foreign companies that list on U.S. exchanges must have their financial statements audited by an independent auditor. Multinational companies are generally audited by firms in their own country. This is true regardless of whether the firm listing in the U.S. is based in China, Russia, Turkey, France or anywhere else.

The Sarbanes-Oxley Act of 2002 established the PCAOB and required that every accounting firm (U.S.-based or foreign) that issues an audit report for an SEC-reporting company to register with the PCAOB.

The PCAOB is required to periodically inspect registered firm audits of U.S. public companies, including those done by foreign firms, and this has caused significant friction with foreign accounting firms and their regulators.

“There has been a reluctance to let the PCAOB come in and inspect their firms,” Daniel Goelzer told me, referring to foreign regulatory agencies. Goelzer is a retired partner in the law firm of Baker McKenzie, was at the PCAOB from 2002 to 2012, and was Acting Chairman from 2009 to 2011.

Over time, the PCAOB negotiated agreements with foreign counterparts that allowed them to perform audit inspections. SEC Chairman Jay Clayton and PCAOB Chairman William D. Duhnke III issued a joint statement in December 2018, noting that the PCAOB had entered into cooperative agreements with 23 foreign regulators which allows them to conduct either joint inspections or share inspection findings with regulators in those jurisdictions.

China, however, is one of the few countries that has not been cooperating with the PCAOB. This leaves China companies caught between two regulators–China and the U.S.

Clayton and Duhnke said that despite attempts at constructive dialogue with Chinese regulators, “[W]e have not yet made satisfactory progress.”

Goelzer agreed, noting that this issue has been around for some time. “There have been constant negotiations for many years, and they intensified after I left in 2012,” but nothing ever came of it, he said.

What’s behind the refusal?

“China has strict secrecy laws, but legal issues asides, there has been a lot of speculation they are concerned about what inspectors might see with regard to the involvement of the Chinese government,” Goelzer said, emphasizing he did not know for sure.

Delisting ‘not a very attractive option’

Goelzer said he generally supports the Rubio bill but with reservations. “It’s unacceptable to have Chinese firms not complying with the rules, but delisting is not a very attractive option,” he said, noting that it would move Chinese companies overseas and thus reduce choices for U.S. investors. Depriving U.S. investors of the opportunity to participate in China’s growth is also not an attractive option, he said.

One thing he is quite sure of: The White House–or the SEC–could not simply delist a Chinese firm by fiat.

The first step, he said, would be for the PCAOB to deregister the auditors, on the grounds that they are not participating in inspections. Because the companies need to have an auditor that is listed with the PCAOB, the SEC (or the exchanges) could then delist the company. This would likely be litigated and could drag on for years, he said.

The joint statement lists other measures that could be taken short of delisting, including “requiring affected companies to make additional disclosures and placing additional restrictions on new securities issuances.”

“My first choice would be for China to see the light, but if that doesn’t happen they may have to pull the plug,” Goelzer says.

Another area that will likely heat up is the battle over indexing. The Trump administration has banned six Chinese companies that work on artificial intelligence from doing business with U.S. firms.

Sen. Rubio and others have led the charge, arguing that global indexing firms like MSCI are now including Chinese companies in global indexes and that U.S. government pension funds should not be investing in these indexes.

Some go farther, arguing that the U.S. should seek to limit the ability of global index providers like MSCI to add Chinese companies to global indexes when the U.S. believes those companies are security threats to the United States.

“If you would like to sell X product in the United States, than they should follow certain guidelines,” which would include respecting fundamental values of the United States, one person involved with the negotiations, who asked to remain anonymous, told me.

For Pat Healy of Issuer Network, who advises companies seeking to list on U.S. exchanges, this is a very slippery slope: Should the U.S. government become the global portfolio manager for the world?

“Everyone will lose if we keep thinking like this,” he told me. “In a free market, if you don’t want to support those kinds of companies, you should not buy them. But the government should not be managing indexes.”

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