2020.11.02 – Emerging Tail-Risk: An Invasion Of Taiwan

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We are not in the habit of peddling conspiracy theories, but a new geopolitical tail-risk is materializing for investors and for global stability. China’s People’s Daily recently published a “Letter to Taiwan’s Intelligence Organs” warning Taiwanese intelligence agencies against supporting President Tsai Ing-wen’s resistance to China’s unification efforts (article in Chinese; Facebook summary in English).

The warning was little noticed by most Western media. What was ominous was the phrase, “Don’t say I didn’t warn you” (勿谓言之不预也). Similar language was used by China when it launched military offensives in the past. It used that phrasing when it issued a “surrender or die” ultimatum to the nationalist garrison in Beijing in 1949; it warned American-led forces in Korea not to approach its Yalu River border in 1950; it warned India before attacking in 1962; and it issued a similar warning before the invasion of Vietnam in 1978.

For investors, the consequence of a Chinese invasion of Taiwan would be a horrific risk-off episode. However, hedging against such an outcome can be problematic. The behaviour of conventional risk-off havens such as the USD, JPY and gold is dependent on how any potential conflict unfolds. The JPY may not be a safe haven in light of Japan’s geographic proximity. USD assets, such as Treasuries, may serve as a counterweight to risky assets to stocks, but it depends on the level of American involvement in the conflict. Similarly, gold prices may spike during wartime, but it tends to be inversely correlated to the USD, and a USD rally could pose a headwind for gold prices.

We believe a better hedging vehicle that acts well in a war, but may not create a drag on portfolio returns, is the Aerospace and Defense industry.