Gearing Up For War
How do investors hedge against the emerging conflict between China and Taiwan
Last week Beijing launched its largest military exercises aimed at Taiwan since 1996. With tensions rising between China and America, the possibility of an escalation between China and Taiwan, be it in the form of a blockade or a full scale war, looms ever more plausible. There would be no escaping the economic and financial fallout that would follow. Thus investors should hedge their portfolios against such a possibility.
Market’s reaction to Russia-Ukraine war
To understand the market effects of a potential China-Taiwan conflict, I start by examining the market reactions to the Russia-Ukraine conflict. I will begin by examining the effects on the bond markets, then move onto equities and other asset classes, then finally onto balance of payment and currency issues.
Bond Markets
The credit default swap markets (CDS) for Russian and Ukrainian sovereign bonds have skyrocketed following the invasion. Current CDS value for Russia sovereign implies a 100% probability of default. [0] Both country’s credit ratings were downgraded.
Equities
Ukrainian and Russian equities have already been declining months before February. On the day of the invasion, Ukrainian Exchange suspended its activities as well as daily operations, except for operations necessary for the central bank's monetary policy and the finance ministry's public debt servicing. The Russian MOEX Index has lost more than 40% of its value in the start of the year.
Commodities
Oil, wheat, and other commodities have inched ever higher after the invasion, because Russia and Ukraine are big oil and wheat producers respectively. Gold prices also increased during the tension build up and especially immediately after the invasion.
Balance of payment
Money flowed out of Ukraine and the Hryvnia depreciated. The Ukrainian central bank has since banned foreign currency purchases on the interbank market and fixed the official hryvnia exchange rate on February 24. [1]
Risks Facing Investors Exposed to Taiwanese Economy
Given that Taiwan produces more than 90% of advanced semiconductors [2], investors who have exposure in big tech firms such as Apple, Nvidia, and AMD have significant exposure to Taiwanese firms.
For Taiwanese investors, home bias, the tendency for investors to over-invest in domestic equities is especially risky. Not only would Taiwan's domestic markets likely crash in the event of a conflict, markets could be suspended altogether, like those in Ukraine. Given that China is Taiwan’s largest trading partner, sanctions could decimate Taiwan’s economy.
The depreciation of the New Taiwan Dollar in the event of a conflict is another major risk. Although Taiwan has the world’s 6th largest foreign currency reserve [3], in the event of a prolonged conflict, Taiwan’s central bank could still depreciate and ban foreign currency purchases, like whats implemented in Ukraine now.
Hedging Strategies
Geographic Diversification
Investors who already have exposure to Taiwan in the form of a career or real estate, should try to avoid further investment into Taiwanese assets. Investing internationally reduces investors’ exposure to the New Taiwan Dollar. One would also benefit from USD’s position as a safe haven if one chooses to invest in the US markets. With recent trends such as onshoring, protectionism, and anti-globalisation, the returns among geographic regions have become less correlated, which creates greater benefits to diversification.
Long Foreign Semiconductor Manufacturers
TSMC’s production would be halted in the event of a conflict, which would create a global shortage of the highest end semiconductors. As semiconductor prices rise due to the shortage, other semiconductor contract manufacturers such as Samsung, Global Foundries, and Intel would receive more contracts. New fabs to replace the lost factories would also be needed, so suppliers to semiconductor manufacturers such as ASML would also face higher demand.
Long American Defence and Defense IT Contractors
As America’s allies in the region grow ever more concerned about China’s assertiveness, their military spending have been rising steadily. Japanese Government added $7.0 billion to military spending in 2021, the highest annual increase since 1972. [3] Australian military spending also increased by 4% in 2021. [4] Shares of Lockheed Martin and Leidos have jumped by 18% and 15% respectfully in the week following the Russian invasion. Northrop Grumman gained 23% in the 2 weeks after.
Long Vietnam Equities
Vietnam has been a winner from the US-China trade war intiated by President Trump since 2017 as many manufacturers in China shifted to Vietnam to escape the sanctions and access cheaper labour. Future geopolitical tensions involving China would further push manufacturers into Vietnam generating high foreign direct investment to support its growth.
Long Commodities
Armed conflicts disrupt supply chains, lead to sanctions, and limit countries' exports. Wars are fueled by commodities. Thus commodities prices would appreciate in times of conflicts. Positions in gold have the added benefit to not being tied to the outcomes of any one country. Past conflicts have led to countries printing more currency to support their spending deficits which ultimately led to depreciations. Countries that lost wars fared even worse as their currency tumbled along with their political standing. In the case of World War Two, gold kept pace with cash for the winners. Gold also protected wealth far better than cash did in the countries that lost. Gold also appreciated at the start of the Russian-Ukraine conflict.
[6]
Stay away from fixed-income
Bond prices around the world fell at the eve of the Russia-Ukraine conflict. Because wars are inflationary, bonds generally underperformed their historical average during periods of war. [7]
Conclusion
Investors already exposed to the Taiwanese economy should avoid adding to that exposure. Rather, they should invest in assets that would benefit in the event of a conflict. Unlike risks in the CAPM model, geopolitical risks facing investors are fat tailed. It all comes down to Xi Jinping. Be sensible and hedge your risks.
Links and References:
[0] http://www.worldgovernmentbonds.com/cds-historical-data/russia/5-years/
[2] https://www.reuters.com/investigates/special-report/taiwan-china-chips/
[3]
https://en.wikipedia.org/wiki/List_of_countries_by_foreign-exchange_reserves
[5]
https://www.sipri.org/sites/default/files/2022-04/fs_2204_milex_2021_0.pdf
[6] https://www.bridgewater.com/research-and-insights/some-perspective-on-gold-in-the-new-paradigm
[7] Hamilton, E. J. (1977). The Role of War in Modern Inflation. The Journal of Economic History, 37(1), 13–19. http://www.jstor.org/stable/2119441
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