Ripples from Pelosi's trip may take time to affect global markets

(Bloomberg) — From an accelerated decoupling of the world’s two largest economies to a debate over whether China could weaponize its vast holdings of government securities, investors are taking stock of how U.S. House Speaker Nancy Pelosi’s visit to Taiwan could to influence global markets.

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Haven assets were shaken as concerns about the level of China’s military response dissipated and Treasuries sold off on hawkish comments from Federal Reserve officials. The yen made a sudden reversal, sinking more than 1% on Tuesday after its strongest four-day stretch of 2020, but rebounded on Wednesday. Most stocks and stock futures struggled for traction.

Pelosi’s visit sparked fresh anxiety among investors already spooked by the threat of a global slowdown amid rising inflation. Some strategists have warned against rejecting China’s initial response too soon – military exercises and some Taiwanese trade restrictions – with markets vulnerable to any hint of a deterioration in Sino-US relations.

“This issue will linger much longer than the market’s attention will allow,” said Michael Avery, head of Asian financial market research at Rabobank. “Yet geostrategists are largely united in the view that we are still alarmingly close to a potential Fourth Taiwan Strait Crisis.”

China and government securities

Investors were still analyzing headlines and market moves on Wednesday for clues about how China might retaliate. The dizzying spike in Treasury yields overnight has sparked discussions about whether Beijing could weaponize its nearly $1 trillion pile of U.S. Treasuries. Shares in China’s defense sector rose, while Taiwan’s transportation and tourism stocks fell.

Volatility hits markets with geopolitics added to array of risks

“Given the scale of the sell-off, it was only a matter of time before there was speculation that China was using its sizable holdings of government Treasuries in retaliation for Pelosi’s visit,” said Ian Lingen, strategist at BMO Capital Markets. “In the event that this is the case (which we doubt), downside behavior should be limited as the short-term effects of the flow are overshadowed by the negative impact on the global macro outlook.”

Others, such as Huang Huiming, a fund manager at Nanjing Jing Heng Investment Management Co., are bracing for the start of Beijing’s “salami tactic” — a piecemeal approach to divide and conquer opposition — and how it could affect the already choked upside along supply chains.

“Looking closely at the exercise areas, this is the closest we’ve ever been to the island and surrounds it — all military operations are initially disguised as exercises,” Huang said. “We may be concerned if drills become longer and more intense to affect supply chains, but there is no sign of that happening now.”

Pelosi will meet with Taiwan’s leader as China opens military exercises

Faster separation

While some investors are looking to sell the rumor, buy the news of Pelosi’s visit for now, others are taking a longer-term macro view of how it could turn out to be a watershed moment in Asia-Pacific history and potentially change the region’s asset allocation . Taiwan is a critical global supplier of semiconductors and other high-tech goods.

There are risks of a longer-term economic decoupling between the world’s two largest economies, with multiple potential impacts, including renewed stress on supply chains, worsening inflation. Beijing has already announced the start of an economic response, halting exports of natural sand to Taiwan and halting imports of fruit and fish.

“The formal return of US influence in the Asia-Pacific region will inevitably accelerate the US-China decoupling,” said Xiadong Bao, a fund manager at Edmond de Rothschild Asset Management in Paris. “Given that this is a developing event, investors should prepare for a test of nerves that could lead to high market volatility in the short term.”

Caution prevails

When everything looks so uncertain, sometimes the biggest deals involve buying the world’s traditional safe havens — Treasuries and the dollar.

That’s the view of Saxo Capital Markets’ Jessica Amir, who believes the latest tension will only fray investors’ nerves further, spurring safer assets to outperform.

“Right now we think the tone is set for stocks for August and the rest of the year.” Geopolitical tensions will rise,” Amir said. “We are also seeing a return to safe havens and the dollar will see increased buying.”

It’s an outlook shared by AMP Capital Markets chief economist Shane Oliver, who sees gains for Treasuries versus gold if the visit sparks an actual conflict. “In the longer term, this signals a further escalation of Cold War tensions between the West and China/Russia, which means higher risk premia,” he said.

A sense of recovery

In Zurich, fund manager Jian Shi Cortesi sees parallels in market performance between Newt Gingrich’s trip to Taiwan in 1997 and Pelosi’s today. Then the Hang Seng index and Taiwan’s stock market fell before the visits, but recovered strongly afterwards. This time, investors saw similar weakness for Chinese, Hong Kong and Taiwanese stocks ahead of Pelosi’s trip.

China’s military exercises near the island of Taiwan “may still keep investors on their toes,” said the chief investment officer at GAM Investment Management. “Market sentiment will recover once the military exercise is over.”

(Updates everywhere.)

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