Markets tend to fall on risks investors aren’t prepared for. Think Covid. Some call this the Black Swan theory. Others call it unknown unknowns.
But the truth is, most of these tail events aren’t unknowable at all. They are entirely foreseeable. The thing about them is they are low probability (thus, tail events) and therefore largely ignored by investors.
Recall, Covid was known in China for a few months before it came to the US and investors yawned. SARS wasn’t that long ago and the idea it could come back as something worse wasn’t unthinkable. In fact, it was expected. That’s why they make movies about pandemics. What we didn’t know was when. But even when we had a hint early last year, we remained blind to the risk.
This brings us to today’s topic: Taiwan. This is a known risk that has been around so long that it gets dismissed, even when the probability has gone up materially. It is incredibly similar to Covid in January of 2020.
The New Cold War
My prediction is Taiwan will mark the official beginning of the Cold War between the US and China. While the geopolitical implications of that are gigantic, that isn’t what will impact markets. There are more direct impacts which we’ll get to momentarily that make Taiwan more important than Hong Kong.
But first, how do we get here? Let’s start with the obvious. China is intent on asserting its authority over Taiwan. Just ask John Cena! China’s crackdowns on independence and the rule of law in Hong Kong suggest that the days of “One Country, Two Systems” are nearing an end.
While we can debate all day long whether Taiwan should be treated as an independent nation or not, that is sort of besides the point. There are arguments on both sides and the lack of clarity has led to the limbo of the past 70 years. What really matters is that China is being more assertive in its claim that Taiwan is part of China.
The other thing that matters is that the US has “guaranteed” the defense of Taiwan. Guaranteed is in quotes because that treaty is interpreted differently by different people as far as what level of commitment is necessary.
Certainly, President Xi will consider how he thinks the US will interpret this commitment when deciding on his own actions. In other words, if he thinks the US will do the minimum to meet its obligations, he is more likely to be hawkish.
While one might assume the Biden administration isn’t looking for a military conflict anywhere in the world and that public opinion is unlikely to take a strong interest in the troubles of Taiwan, there are some considerable other issues to consider that could press the US to take a strong stand.
Taiwan Semiconductor
Taiwan Semiconductor, also known as TSMC, is arguably more important to the world’s economy than Saudi Arabian oil. It is the leading maker of chips for everything from smart phones to cars.
While China has become a leading manufacturer in many important industries, one of the places it still lags badly is semiconductors. Thus, asserting its control over Taiwan for geopolitical reasons comes with a big, giant bonus: the potential for state control over TSMC.
This wouldn’t just solve a technological problem for China. It would also create the potential to use TSMC as a weapon against the West, particularly the US. If TSMC cut off supplies to US companies, it would blow the socks off the OPEC crisis of the 70s.
To be clear, it is very possible China tries to take over Taiwan without changing to whom TSMC sells their products. However, at a minimum, there would be an ever present threat that China could cut off US tech companies at any time. This is why the Biden administration is trying to help US semi manufacturers (although it is unlikely to be enough to change the calculus).
I clearly can’t know how China thinks about this strategically. Do they view asserting their control over Taiwan as the main goal and TSMC as a secondary benefit? Or is TSMC the main thing they are after and any political gains from ending Taiwanese independence as the side show? I have a strong suspicion that it’s the latter.
Why? Because it opens up so many more doors. Yes, there is the downside of formalizing a Cold War with the US. However, having the ability to commit the equivalent of economic nuclear war is an incredibly powerful tool.
The US clearly knows this and, if they believe that China gaining control over Taiwan will directly impact TSMC, game theory suggests they are more likely to intervene and defend Taiwan.
Would we really go to war over semiconductors? Doubtful, but we have gone to war over oil and I would argue semis are more important today than oil was in the past.
So, we have a powder keg. If there is any fighting over Taiwan, the market tanks. If the US lets China take Taiwan, the market tanks. If China takes Taiwan and control over TSMC, the market is down 30+%. The only good outcome is China remains patient and doesn’t act. The expected value of those scenarios doesn’t seem favorable.
The Risk to Renewables
But wait, there’s more! Let’s envision another outcome. China threatens Taiwan. The US sends ships to deter them and we have a stalemate with tensions high. What happens next? A relief rally that the worst case didn’t happen? Possibly, but China has other tools.
Let’s return to the OPEC analogy. China is quickly becoming the OPEC of renewable energy. They control the production of batteries. They control the production of solar panels and they are the largest source of wind turbines. While the Biden administration is attempting to address this, just like the semi shortage, it will likely be too little, too late.
Why is that important? One way China can hurt us is by cutting off all of those supplies. Less immediately damaging than losing our semi access, but not so good if you’re trying to diversify away from oil.
Could China pressure the US to back down on Taiwan to preserve access to renewable energy supplies? Would the US risk its access to semis to preserve its environmental progress? These are complicated choices, but generally speaking, China is dealing from a position of strength.
One way or another, it is likely any disturbance to Taiwan will be destabilizing to markets. You can also throw in to the mix things like China divesting its Treasuries or cracking down further on Bitcoin. There are many paths to poor outcomes for investors.
Multiple Mix Shift
It is worth pointing out one other thing. A disruption to oil supplies impacts low multiple stocks (energy producers, auto manufacturers, etc.). The Financial Crisis impacted low multiple stocks (banks and mortgage lenders).
A disruption to semis, all the tech companies that buy semis, and the renewable energy sector impact high multiple stocks. A selloff in Treasures raises rates which lowers valuations across the entire market.
Thus, we are talking about a shock that has a multiplier effect on multiples. The bigger market cap stocks with the highest valuations take the most pain. This makes it reminiscent of 2000.
How to Hedge
It’s not easy. For example, my first thought was short treasuries because supply restrictions are inflationary and China may sell their holdings. On the other hand, investors tend to buy Treasuries during a crisis and the Fed would probably return to buying every Treasury they can find.
Buy NASDAQ puts? Not the worst idea, but while you’re waiting on China to act, you may be flushing a lot of premium down the drain. Hard to say whether that’s a profitable trade or not.
Buy Western producers of semis because prices would go up? Possibly. There are some issues where different producers make different types of chips which they can’t easily switch. If Apple needs a certain chip to make phones and only TSMC has it, there isn’t an immediate solution from another manufacturer.
You also have to consider that a general economic downturn is bad for semi demand. Still, this makes more sense than the other ideas.
Defense stocks? If we are starting a new Cold War, presumably defense budgets would have to rise. There aren’t that many public companies left to choose from, but this would be a pretty good bet.
In a similar vein, you’d probably want to consider US centric manufacturers. If we can’t rely as much on China for making cheap goods, we will need to move production back home.
You’re already seeing the government get involved trying to move things like semi production back to the US. Over time, more industries could be deemed essential. This could be a long lived trend.
Oh, and don’t forget gold. Gold is a safety asset and an economic Cold War is likely inflationary. Gold should do very well.
Prepare, Don’t Panic
Final thought. Just because I make this sound scary doesn’t mean it will happen. This is a tail event. There are lots of tail events that can happen at any time. The key is to be prepared. As I said, the risk of this tail event is elevated compared to others and the consequences are severe.
Therefore, you should do your homework and understand what it might mean if it happens. Unlike say an earthquake, the ongoing impacts of a Taiwan confrontation will be long lasting and affect the every day life of everyone in both countries. It’s worth spending some time reading up on the possible impacts.