(Source: Quint)

The Biggest Risk That Markets Ignore

BloombergOpinion

(Bloomberg Opinion) -- No matter how well markets are doing now, there is always the possibility that some rare but devastating event will make it financially or even physically impossible for investors to preserve their wealth. The most important of these giant, hidden risks, as economist Brad DeLong cited in a 2014 post on threats to the bull market, is “war, and rumors of war.”

You don’t see people in the finance world talking much about war these days. It didn’t appear on my Bloomberg Opinion colleague Mohamed El-Erian’s list of the biggest risks facing U.S. equity investors, nor on many other such lists. A few have mentioned the danger of clashes over North Korea or the South China Sea, but the danger has still mostly stayed off the financial media’s radar screens, as attention focuses on the U.S. trade wars or the Turkish economic crisis.

But this could indicate a dangerous complacency. It wouldn’t be the first time, either — markets famously failed to predict the coming of World War I, despite decades of rising tensions. With stocks still near record highs even as the international climate darkens, investors just might be repeating the errors of history.

The biggest danger by far is a war between the U.S. and China. How likely is such a war? The answer is that no one really knows. Recent experience would suggest not very — the U.S. and the Soviet Union avoided direct conflict for a half-century, thanks to nuclear weapons and mutually assured destruction. But some theories of international relations suggest that some kind of conflict between the two is inevitable. The risk is that a prolonged level of high tensions could accidentally flare up into a shooting match no one wants, something that almost happened several times during the Cold War.

And tensions are certainly high between the world’s two largest economies. North Korea’s nuclear program is one obvious and long-standing flashpoint, as is Taiwan. But the most dangerous region might be the South China Sea. In the past few years, China has attempted to extend de facto sovereignty over a maritime region that the U.S. and most other nations claim should be subject to freedom of navigation by any country. In order to make it clear that it hasn’t surrendered to China’s claims, the U.S. has regularly sent warships through the disputed area. Meanwhile, China is building artificial islands and military bases there.

This situation has been long in the making, but scary stories about the region now appear with alarming frequency. A U.S. destroyer had an unsafe interaction with a Chinese warship. China canceled a high-level security meeting with the U.S. An American guided missile destroyer sailed close to an island claimed by China. After U.S. bombers flew over the South China Sea, Chinese jets held live-fire drills there. These stories appeared in just one three-day period — Sept. 29 through Oct. 1. Meanwhile, the U.S.-China trade war launched by President Donald Trump is obviously adding to the tensions between the two countries.

Many have asserted that China and the U.S. are too economically dependent on each other to go to war — China needs the U.S. to buy its exports, while the U.S. needs China to buy its bonds. But this argument ignores history — on the eve of World War I, Britain and Germany were each other’s top trading partners, and that didn’t stop them from plunging into Armageddon. Furthermore, the threat of China’s financial power over the U.S. is exaggerated — China has at times reduced its holding of Treasuries in recent years, with no apparent negative consequences for the U.S.:

The Biggest Risk That Markets Ignore

As for China’s dependence on U.S. markets, the trade war might convince the Chinese that relying on American customers is a bad idea. Nor can China continue to rely on U.S. tech, as was demonstrated when the U.S. imposed a seven-year ban on technology purchases by Chinese telecommunications hardware maker ZTE. China’s leaders might now be calculating that preserving their economic links with the U.S. is a lost cause.

The economic consequences of a U.S.-China war would be devastating, even if it didn’t degenerate into a global nuclear holocaust. A small, indecisive clash between warships in the South China Sea would signal that the era of economic symbiosis between the two giant economies — and with it, the global-trade regime that has developed since the turn of the century — has come to an end. Supply chains across the world would unwind rapidly and painfully, as multinational companies scrambled to diversify their production bases and intermediate goods purchases. That could cause economic chaos, recession and the losses of gains from trade.

How can investors hedge against this risk? There are probably strategies beyond simply moving money out of the markets and keeping it in gold or Treasury bonds. Companies that are already in the process of diversifying away from China might be less hard-hit in case of a breakdown in the U.S.-China relationship.

But the most important message is to think more carefully about this most ominous of global risks. There is a chance that great-power war is truly and permanently a thing of the past — that modern weapons and the comfort of modern prosperity have relegated it to the history books. But don’t bet everything on that chance.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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