U.S.-China Tensions
Some context on recent news
Since the last piece, the fall in commodity prices has begun to filter through inflation data. Today’s inflation print came in at +8.5 percent for July year-on-year, a slowdown from June (economists were expecting a +8.7 percent jump). Energy prices declined to +4.6 percent while gasoline “only” +7.7 percent.
Lower inflation pressures mean less pressure on the Fed to raise rates, which in turn means higher valuations for high-growth companies. In short, while we’re not out of the woods yet, we’re well on our way to getting there.
There are still many risks facing the market these days, however. One of them is persistent U.S. - China tensions, a risk I’ll be highlighting today.
Nancy Pelosi’s visit to Taiwan came and went without much of an impact on markets. The conclusion from this was that markets did not anticipate the drills would escalate into a confrontation. Given the Party Congress to occur later this year in China, the market seems to anticipate President Xi wouldn’t risk a disaster playing out before the beginning of his likely self-imposed third term.
The exercise did, however, gave us glimpses of what type of strategy the Mainland may use to take over Taiwan. Many war gamers had previously expected the Mainland might utilize a “flatten into submission” strategy where Mainland forces bomb the island into submission.
Instead, we saw something different: the drills involved a blockade, which involved more than 100 fighter planes, helicopters, and more than 10 frigates and destroyers surrounding key ports, preventing the island from getting aid from the U.S. or Japan.
A full blockade over Taiwan would be an act of war, and as war games have illustrated, would take a considerable toll on Taiwanese, Chinese and U.S. militaries. It’s hard to see how China could use such an attack and also claim the moral high ground for becoming a “world power.”
China instead might choose to surround the island but selectively allow food to enter the island, called the “quarantine” option. This approach puts the burden of escalation on incoming ships, which would need to decide whether to cooperate or resist.
Assuming this strategy, China could also enact considerable pain on the world through leverage over key exports. Chinese leaders have likely learned many lessons from the Russia-Ukraine crisis. The Russian ruble has shown resilience against sanctions due to strict capital controls as well as strict penalties on holding currencies from “unfriendly” states. Meanwhile, the jump in oil and wheat prices has only helped the Russian economy, while Germany faces gas rationing and the U.S. stands on the brink of recession.
In short, Russia has turned the consequences of the conflict to its own advantage quite easily.
China would likely similarly utilize leverage on international markets by cutting off foreign investment to Taiwan supporters. China now has hugely successful global brands such as Tencent, Alibaba, Moutai, Huawei, Douyin, and JD that regularly outperform foreign companies in their domestic market. Kicking out foreign companies would not be a huge sting for China’s consumers, but would be a huge knock on foreign companies’ bottom lines.
China could also cut off supplies of semiconductors to Taiwan's allies. A quarantine would give China sudden access to the world’s largest producer of semiconductors. Taiwanese manufacturer TSMC manufactures nearly 50 percent of all the semiconductors in the world and 90 percent of all semiconductor supplies to the U.S. The consequences of this on America’s tech sector would be catastrophic and was a major reason why Pelosi visited TSMC during her trip.
China would likely cut off rare-earth supplies to the world which would be a massive supply disruption for the U.S. tech sector. China has the largest supply of rare earth minerals in the world. And by a long shot.
Rare earth metals are used to make critical technology components. Neodymium, for instance, is used in nickel metal hydride batteries, loudspeakers and computer hard drives, and is produced primarily in China. A cut in rare earth access would create hardware supply-chain snarls that make the recent covid logistical nightmares look like cat’s play.
Apple’s iPhone, for instance, contains notable amounts of rare-earth metals. The color screen, the glass polishing, the phone circuitry, the speakers, and the vibration unit all require critical rare earth elements.
There is speculation that Apple could produce the iPhone without rare earth elements via material substitution, but the resulting product would still not be the iPhone Americans love to use. It would likely be bigger, less power efficient, unable to produce greens or reds, and require more stable temperatures (source: Apple's Dirty Little Rare Earth Secret). Make no mistake - a sudden cut in rare-earth supplies would hit every American’s livelihood, even beyond the pain caused by cuts in oil and gas from Russia.
Due to these reasons, a quarantine strategy by China would likely lead to several market reactions, including:
a pronounced drop in most technology stocks, particularly those linked to hardware production. Large tech companies including AMD, Apple, and NVIDIA depend on Taiwan chip manufacturer TSMC for at least a portion of their chip production. While many U.S. companies have been trying to reduce such reliance, they are mostly in the early stages of this phase.
a sharp drop in most U.S. equity indices. With so many trade ties between China and the U.S., the repercussions on U.S. equities could be anywhere from pronounced to catastrophic (i.e. 10-20 percent declines). China is still one of America’s largest trade partners and is a major supplier of everything from electronic machinery to metals, textiles, and rubber.
a sudden rise in U.S. Treasury yields. China’s central bank is the second largest owner of U.S. Treasuries outside of Japan. China used to be the largest owner, but as China has worked to diversify its holdings (likely to reduce its dependency on U.S. debt markets for liquidity), it has sold Treasuries or moved them to external asset managers. In the case of a move on Taiwan, we might expect China to engage in financial warfare by dumping U.S. Treasuries as a way to punish the U.S. government. Such a move might be dramatic in its early phases but the effect would likely fade as demand from other countries kicks in. Even if China didn’t engage in selling, the threat of such a move could move markets.
USD volatility. A sell-off in U.S. Treasuries would likely result in a decline in the U.S. dollar, all else equal. However, other forces may be at work in such a scenario. Many foreign investors invest in U.S. assets when global turmoil looms, so sudden outflows by China would be countered by other foreign investors taking long U.S. dollar positions. How the end result might look is too difficult to forecast, but expect volatility either way.
The timing of such a move is likely not for several years (mid to late 2020s) if it comes at all, but as with any and all political risks, it’s good to be prepared. President Xi has numerous challenges facing his nation: lingering covid lockdowns, a slowing economy, and likely silently growing dissent within Party leadership (specifical allies to former President Hu Jintao and Premier Li Keqiang) for his ever-encroaching anti-corruption measures. By some measures, the headaches associated with a move on Taiwan would be the last thing he needs now. But then again, a win on Taiwan might be the very thing he needs to justify his third term.
We’ll dig deeper into hedging strategies in a future post.
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