China is again a risk for the U.S. stock market, but this time the issue isn't a tariff battle or China's stranglehold on rare-earth minerals.
The latest tension point is something much more dear to investors: the trajectory of artificial intelligence development.
As Chinese start-ups like Moonshot AI, backed by Alibaba Group, and DeepSeek release more AI models priced far lower than U.S. options, U.S. policymakers are grappling with how to deal with this growing rivalry. Investors will be watching closely: at stake are the profitability of AI companies and the economics of the AI ecosystem more broadly.
Many of these Chinese AI models are open source or open weight, allowing licenses that permit the models to be deployed locally or via cloud providers without paying royalties to the developers.
That makes them popular among many types of U.S. companies for many non-frontier or near-frontier tasks, threatening the pricing power or revenue prospects of models created by Anthropic and OpenAI, says Laila Khawaja, director of Gavekal Technologies.
If the U.S. restricts access to these Chinese open models, it could protect Anthropic and OpenAI from low-cost competition but increase the costs for U.S. users, potentially putting them at a disadvantage to European and other global rivals who continue to have access to the cheaper models. It could also slow AI adoption, potentially dimming the revenue prospects of Nvidia and other chip makers as well as U.S. cloud companies that benefit from serving the Chinese models, analysts say.
Monthly token usage of Chinese models has exploded, with usage 70% higher than for U.S. models in June and Chinese models steadily gaining market share, says Apollo Chief Economist Torsten Sløk. Even with U.S. restriction on China's access to advanced chips, U.S. frontier models are just a couple months ahead of Chinese models he adds.
The rapid development is a reason investors need to closely watch how this geopolitical rivalry is evolving.
"This battle between open source and closed source and what's going on with D.C. is absolutely critical for this point on how this is going to end," Sløk says, referring to what type of restrictions or AI policies come out of the White House and regulators.
For now, the U.S. is still ahead in terms of compute and access to high-tech semiconductor chips.
Ryan Fedasiuk, a fellow at the American Enterprise Institute who previously served as an advisor for U.S.-China affairs in the State Department, expects American chip companies, including Nvidia, Amazon.com and Google, to produce 14,600 MW of energizable compute this year -- almost 20 times what China's leading company Huawei can produce.
But Fedasiuk says China will be able to break its chip dependence by 2028. During the first Trump administration, the U.S. imposed a spate of restrictions against Huawei and tried to push allies to remove the Chinese company's networking equipment from their 5G infrastructure -- a push that was largely unsuccessful, he notes.
"We should be fearful of Huawei replicating that in AI infrastructure," Fedasiuk says. "We need to take a proactive approach to get U.S. chips in sockets before Chinese production comesonline and learn from the mistake in 2010 to make sure American suppliers get there first."
Analysts see the main focus as preserving the lead of American frontier labs, including by addressing proper use of distillation, an AI-training technique that uses queries to other AI models to build its own.
In a recent social media post, Michael Krastios, the White House's Science and Technology advisor, has alleged that Chinese start-up Moonshot's Kimi K3 model, which the firm plans to allow to be downloaded free, used "industrial" or large-scale distillation of Anthropic's model to create its own.
While "legitimate" AI distillation aimed at creating smaller, more efficient models is an important part of innovation in the industry, Krastios said "large-scale, covert industrial distillation aimed at stealing proprietary U.S. technology and undermining American research is unacceptable."
The comment comes amid warnings from U.S. AI executives about cheap China AI models.
The China's Ministry of Commerce pushed back on talk of potential U.S. restrictions or sanctions and distillation allegations, and warned it would react to any action that cause "substantive" harm to China's interests.
"These practices lack factual basis, have no legal grounding, and apply double standards in practice. They constitute a typical form of AI hegemonism. Innovation isn't the preserve of any single party," it said in a statement this week.
Beijing called on the U.S. to work with China to jointly develop AI and improve AI governance. The U.S. and China are expected to talk about AI ahead of the Sept. 24 meeting between President Donald Trump and Chinese leader Xi Jinping.
Analysts are skeptical of major U.S. restrictions ahead of the September meeting, as both sides have stressed stability in the relationship. But analysts expect China to continue to seek a reprieve from export controls on advanced chips and other technology, and the U.S. will continue to push to ensure access to rare earths from China.
It's AI, rather than tariffs, that is likely to be the biggest friction point in the relationship.
China's cheaper models boost adoption of its AI ecosystem in emerging markets, helping its broader geopolitical aims and efforts to position itself as an alternative to the U.S.-led technology ecosystem, in AI but also green energy and computing infrastructure, says Jefferies analyst Edison Lee in a note to clients.
For investors, keeping tabs on what types of measures the U.S. could put in place will be important.
Gavekal's Khawaja is monitoring whether the U.S. tightens restrictions for chips and chip-making equipment or expands restrictions to target AI models or even U.S. companies serving Chinese models through commercial partnerships. For example, the licenses for Chinese open-source Kimi K3's model require cloud providers to strike a commercial pact related to some low user and revenue thresholds.
She is also looking to see if the U.S. sanctions Chinese AI developers, potentially over violation of export controls as most still train on banned Nvidia chips. AEI's Fedasiuk also sees sanctions, such as against AI labs the U.S. alleges are engaging in industrial-level distillation, a way to take action but allow users to download Chinese AI models.
Another option: Using the U.S. advantage in AI compute. In return for selling some of that compute to the United Arab of Emirates or Saudi Arabia, Fedasiuk says, the U.S. can require a "trust and verification" regime to make sure that the compute the U.S. sells them don't end up rerouted to China.
"It's a price Washington can reasonably ask, but this window is closing, especially as Huawei becomes more capable," he adds.
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