Apple's China situation is an 'albatross' investors fear as trade war gets real

Speaking on television last week, Trump's Commerce Secretary Wilbur Ross made an unusual statement about the White House tariff plans, specifically about carve-outs for Mexico and Canada. Ross called the administration's definition of national security something new and unusual itself. "It's not the conventional definition of national security," Ross said.

It's clear from Trump's post-tax-cut shift to correcting imbalances in global trade — something Trump has cared about for a lot longer and with a lot more passion than tax policy — that an evolving definition of national security is a geopolitical and stock market risk.

Panic, on either front, would be an overstatement. The real threat from the new metals tariffs is that a broader, global trade war would have unintended and unpredictable consequences. And in the stock market context, a national security-defined trade war could be more significant — and harder to account for — in the market's best and most widely invested sector: technology. The damage could be much bigger than the "rounding error" within Apple earnings from the steel and aluminum trade penalties.

Those fears came into much starker relief on Tuesday when reports surfaced that Trump wanted $60 billion in trade penalties directed at the Chinese, and a day after Trump killed a huge cross-border technology sector acquisition based on national security concerns. CNBC reported late on Tuesday that Trump is considering indefinite tariffs and investment restrictions targeting the Chinese tech and telecom sectors.

"With potential trade wars with China front and center, and tariffs looking like the Fort Sumter that could set off a battle royale with tech space getting caught up in the crosshairs, we believe the moving definition of national security interests has gone from background noise to a more relevant issue for tech investors," said Daniel Ives, chief strategy officer and head of technology research at GBH Insights, and the analyst who said this week that the steel and metal tariffs specifically were an Apple earnings' rounding error.

"China has some fighting words, and Silicon Valley and the Street are starting to get nervous with Trump igniting the match," Ives said.

There's been a year's worth of headlines reinforcing the point that technology companies can't hide from "national security" headlines. Russian meddling in elections through Facebook, of course. But much more.

U.S. intel chiefs alleging that widely used antivirus software from Russian tech start-up Kaspersky Lab has KGB "bugs" embedded within it — which led Best Buy to pull the product last September even though Kaspersky's founder, a graduate of a KGB cryptology school and former Soviet military engineer, denies it. You don't hear the U.S. government warning Americans about all of the cybersecurity companies to come out of Israel's government defense agencies.

Palantir, the secretive Silicon Valley start-up that has U.S. government intelligence contracts, came on CNBC this week to say that its margins will be impressive when investors see them. Though Palantir being Palantir, the company made no effort to actually show the numbers. One of its own investors said he'd be happiest if Palantir never went public.

Tech stock investors don't have to worry about privately held Palantir or Kaspersky, but any Qualcomm investor already knows that the national security issue is a legitimate and growing one.

In a letter this week from Broadcom's chief to the U.S. Congress, the Singapore-based company stated it would not sell any critical national security assets to any foreign companies if its $117 billion deal to buy chipmaker Qualcomm is approved. On Monday, Sen. Tom Cotton, a vocal Republican voice on foreign policy, said, "Qualcomm's work is too important to our national security to let it fall into the hands of a foreign company."

Cotton won that argument — Trump stopped the deal dead in its tracks for "national security" reasons.

The Broadcom furor comes not too long after AT&T backed out of a deal to sell smartphones from Chinese company Huawei in the United States — allegedly under pressure from lawmakers. In maybe the most surprising move, U.S. intel chiefs announced last month in congressional hearings that they would advise Americans not to buy smartphones made by Chinese companies, including Huawei.

Intel chiefs have long warned about Chinese telecom company ZTE and its telecom infrastructure equipment. The U.S. government has also long referred to Huawei as "effectively an arm of the Chinese government." The United States blocked Huawei and ZTE from bidding on a Sprint roll-out as far back as 2010 and investigated them in detail in 2012. The United States also has barred multiple Huawei investments.

But the warnings previously had not been taken to the level of the smartphone itself, which puts this national security dust-up squarely in the sweet spot of the market's most beloved stock, and a stock whose fortunes are increasingly tied to sales in China: Apple.

Tempers have been running hot: Huawei's chief said earlier this year as national security issues flared up that the United States is trying to stifle competition among phone makers. Just last week one of Huawei's top executives called the developments in the United States "ridiculous" and "unfair" — and Huawei moved immediately to distance itself as a company from the comments.

"Right now the Street is largely dismissing the national security issues on tech, although the Qualcomm move was a wake-up call and the Apple/China situation is an albatross investors are trying to handicap," Ives said.

On Tuesday, after headlines that Trump was reportedly looking for $60 billion in tariffs on Chinese products hit the wires, tech stocks sold off. To be clear, it was also a risk-off day for the stock market with the firing of Secretary of State Rex Tillerson, and tech stocks which have seen big gains can make big moves when investors get a surprise. And Apple shares had just hit an all-time high on Monday, even smid signs that the Broadcom deal was likely doomed.

But even before the Broadcom deal was killed by Trump and the $60 billion in potential Chinese penalties was being reported, investors were starting to discount some risk from a potential China trade war and run through worst-case and best-case scenarios for the top 15 to 20 tech vendors, Ives said. From FANG names to chip plays, Wall Street is modeling the potential financial risk on both the top and bottom line for tech names and which vendors are most exposed.

Qualcomm is the most at risk if China walks the walks instead of just talking the talk, Ives said. "With Qualcomm depending on China for a good piece of its renaissance of growth, and with the Broadcom bid up in the air, they have the most to lose in our opinion, and it's a worry for investors."

Apple and Qualcomm media teams did not respond to requests for comment.

Many China analysts believe it's the Chinese government that has had this coming, because when it comes to technology, China's own practices reflect the broader claims about "unfair" trade policies.

"In China the line between industrial policy and national security policy is super-thin to sometimes nonexistent," said Scott Kennedy, deputy director at the Center for Strategic and International Studies. "They use national security arguments to promote industrial policy outcomes. ... Their existing regulatory environment is highly discriminatory against American and foreign telcos," Kennedy said.

He said China could make a highly protectionist system even worse and go one step further and make life more difficult for American companies. But he added, "I don't think anything said by the U.S. government would bring it close to what the Chinese already do. ... In terms of due process, you can't defend the U.S. from top to bottom, but the U.S. does have a relatively robust system with some checks and balances, while China has none."

Kennedy doesn't believe that the rhetoric from U.S. officials has reached a level equivalent to China, where industrial policy and national security policy are deeply entwined, but he was surprised that the intel chiefs went as far as advising Americans to stay away from Chinese smartphones. He noted it was not in written statements, but instead revealed by intel chiefs as part of responses to hearing questions posed by politicians.

"It wasn't clear how precisely they meant to refer to handsets. They could be right that our cellphones are vulnerable to surveillance. Where they had been before [the handset warning] was more concern about equipment. Telecom equipment has been a longtime concern, and that's not industrial policy," Kennedy said.

He also noted that any American consumer can buy a Huawei phone or a phone from another big Chinese phone maker, Xiaomi, right off the shelf and then go to AT&T or Verizon and have it turned on. He also contended that, like Palantir, being private allows Huawei to share as much or as little information as it wants.

Ives said that no Apple investor should ignore the basic fact that "Apple now is in the middle of a U.S.-China tug-of-war."

Ives said his team tries to quantify the worst-case financial implications for Apple if the trade war and growing national security shadow impedes growth and/or causes cost issues for Apple CEO Tim Cook and the company. The Foxconn situation — the largest Apple iPhone production facility is Foxconn's mainland China "Foxconn City" — is top of mind, the tech analyst said.

"Clearly, we have a very dynamic environment. The U.S. and China are both deeply integrated with each other and embedded in production and innovation networks and there is deep and growing mistrust also," Kennedy said. "That is an environment waiting for tension to emerge and grow, and without very clear international standards on how to resolve and low trust, we will continue to see these tensions," Kennedy said.

He said also strict Chinese regulations are likely to become tighter and more troubling.

"I guess if we up the ante and the Chinese respond a trade war could include additional collateral damage. Apple is an easy target because it is so large and would be quite visible," Kennedy said. But he does not think Apple is a good target for the Chinese because Foxconn City in Shenzhen, China employs up to 400,000 people (though exact numbers are hard to get) and is supported by the Chinese government, and is possibly the largest factory in the history of the world.

There's U.S. geography to consider as well. Foxconn has started construction on a large plant in Wisconsin, since Trump was elected. Punishing Apple may not make much sense either.

"Since Apple is in California, punishing Apple won't make Trump feel too worried about his 2020 election chances," Kennedy said. "They ought to be looking at the Midwest and purple counties: soybeans. ... They don't have to go apples-to-apples in this case, and the Chinese are very creative," when it comes to trade war, he said.

Derek Scissors, American Enterprise Institute resident scholar and China expert, said he also believes Apple's contractor in China employs too many Chinese citizens for the tech giant to be a direct target. Intel, as well, continues to grow in China and the Chinese "don't seem unhappy with it." However, recent reports on an Intel chip security flaw also alleged that Intel told big Chinese tech companies like Lenovo about the flaw before it told the U.S. government.

The latest turn in the Broadcom-Qualcomm saga emerged late last Friday, when a report surfaced that Intel may be considering a takeover of Broadcom.

"If had to pick a single company to see a share price drop on a US-China trade conflict, it still would be Boeing. But I think Qualcomm faces the most China-related volatility," Scissors said.

That volatility may rise or fall based on the outcome of the Trump administration's current investigation under Section 301 of the Trade Act of 1974. It is being directed by U.S Trade Representative Robert Lighthizer, arguably "the most powerful Trump official you've never heard of."

The $60 billion penalties reportedly being sought by Trump would fall under the Section 301 review. Reports on Tuesday day Lighthizer had initially proposed a $30 billion plan to the White House and been told by Trump that the president wanted more.

Section 301, arguably the most powerful piece of arcane trade law to be batted between the U.S. and Chinese tech sectors that most investors have never heard of, allows for a review of "Chinese laws, policies, and practices which may be harming American intellectual property rights, innovation, or technology development."

Lighthizer is similar to Peter Navarro — the Trump economic adviser closely associated with the steel and aluminum tariffs — in being an ideologically conservative trade hawk who embraces many protectionist stances.

Both Kennedy and Scissors said whatever comes out of that investigation will loom large in a response from China.

"Qualcomm is an obvious target," Scissors said. "They have already tried to coerce [Qualcomm] into sharing more advanced technology."

He said if Qualcomm holds fast through that, and the U.S. hits China with meaningful sanctions under 301, he wouldn't be surprised if the Chinese tell Qualcomm that their license agreements are void. If there are 301 sanctions and an ultimately, Qualcomm complies with China's demands, it would be a net win for China, he added.

"I think Qualcomm is at least as plausible, if it remains independent and doesn't cave on tech transfer," Kennedy said. But the American Enterprise Institute analyst said he wouldn't be surprised if the Chinese ultimately opt to "hit back" in a manner that wouldn't surprise, targeting agriculture and soybeans.

Scissors said that while the 301 investigation is a new and potentially serious policy change, he thinks even more potent is the CFIUS bill being considered on Capitol Hill and issued with bipartisan support from the Committee on Foreign Investment in the United States. CFIUS — an interagency committee authorized to review transactions that could result in control of a U.S. business by a foreign person.

CFIUS was already "not happy" with Broadcom's attempt to relocate its headquarters to the U.S. without telling the government, in a bid to avoid deal scrutiny, the day before Trump ended the issue.

"Where it goes from here depends on how the Trump administration decides to punish the Chinese as a result of the 301 investigation," Kennedy said. "If Trump comes out with significant penalties ... one more piece on a pile of growing tensions."

Scissors view on Chinese telecom has always been the same: "Huawei and ZTE have always been unacceptable for any major role in the U.S. market."

More from Global Investing Hot Spots:

Trump's steel war with China was over before he started it

Apple's surprise move into the rare metals market

China's role in the trillion-dollar race to control the Arctic

Updated to include Trump's move to kill the Broadcom-Qualcomm deal on Monday, and a report on Tuesday that the president is seeking $60 billion in trade penalties against China.