Thinking through the unthinkable: wars in Europe, the Middle East and Asia

Horizons article
October 24, 2023

In the aftermath of October 7’s tragic terrorist attack in Israel by Hamas, a key question is whether the U.S. will become involved in a two-front conflict, clashing with Russia in Ukraine and Iran in the Middle East. The significant probability of such a scenario is raising another question: what is the probability of a third front emerging in Asia, with the United States confronting China, possibly around Taiwan? All of this may seem extreme, but as investors, we must try to assess the likelihood of such a scenario and analyze its potential impact on financial markets. Of utmost importance is to identify the regions most vulnerable. Based on our research, we conclude that, in the scenario of a conflict around Taiwan, a low exposure to Chinese markets, which is favored by investors, may not present a viable solution.

The few studies that examine the potential impact of a conflict around Taiwan argue that the Chinese economy would suffer the worst of the consequences. This is primarily due to disruption of maritime trade, which would curtail China’s import of food and energy. For example, a 2016 study conducted by the RAND Corporation argued that in the event of a yearlong conflict between the United States and China, the U.S. would see a 5-10% reduction in its GDP, while China would suffer a much more significant blow, with a 25-35% decrease in its GDP (to put these numbers in perspective, the global financial crisis of 2008 led to a 4% reduction in the GDP of the U.S). Meanwhile, a 2022 report by the Rhodium Group argued that even in the absence of military escalation between the U.S. and China, a blockade of Taiwan by China would lead to the destruction of two trillion dollars in trade, primarily affecting Chinese trade with the rest of the world.

These studies, that argue China is most vulnerable to a conflict around Taiwan, focus on the metric of GDP. However, there is also the matter of supply chain disruptions, which paint a different picture.

We should not forget that prior to the Russian invasion of Ukraine, the prevailing argument among investors was that the limited share of global GDP held by Russia would insulate global markets from the impact of a war. In hindsight, disruptions in the energy and food supply chains surprised both American and European markets and caused a massive inflationary shock.

From the perspective of supply chains, Western markets could suffer just as much as China from a conflict around Taiwan. The main reason is that China (like Russia) could choose to disrupt vital supply chains for major Western businesses. Of the “Magnificent 7”, the seven American tech companies that currently drive nearly all of the U.S. stock market growth, some are highly dependent on Chinese suppliers. Nearly 40% of the suppliers for materials used in Tesla's electric vehicle batteries are Chinese companies and more than 95% of Apple’s iPhones, AirPods, Macs and iPads are made in China. The same applies to the German automotive sector (which accounts for nearly 24% of Germany's total corporate revenue) as Chinese companies are the key suppliers of batteries that are needed for German car manufacturers' transition to electric vehicles. Besides these supply chains, Western businesses like Nvidia, Volkswagen and LVMH are also highly dependent on access to Chinese markets – which can be cut off by China in the scenario of a conflict around Taiwan. In summary, it is likely that a conflict around Taiwan would hit Western markets just as hard as Chinese markets.

Generally, investors seem to assume that a low exposure to Chinese markets will protect a portfolio from conflict between the West and China. However, as we have shown, this may not hold true. Considering the over-exposure of investors to Western markets, as illustrated by the discrepancy between GDP and geographical equity allocation (see the graph below), most investors are not prepared for an escalation of conflict around Taiwan:

Source: Bloomberg L.P.

All of this implies that a low exposure to Chinese markets will not safeguard an investment portfolio against a conflict around Taiwan. Instead, investors who seek protection against international conflicts (like the scenario of wars in Europe, the Middle East and Asia) would be wise to explore different strategies, like diversifying geographically and among asset classes.



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