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EDITORIAL COMMENTARY

China’s Military: What It Means for Markets

Investors must prepare for the possibility of a Great Power conflict between the U.S. and China.

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PETER NAVARRO

December 26, 2015

China’s factories are now rapidly producing military capabilities that will eventually rival those of the U.S. The only remaining debate is whether China will achieve parity by 2020, 2030, or later.

China’s capabilities already include the world’s most diverse missile threat, the fastest-growing diesel-electric submarine fleet, and new nuclear subs capable of striking any city in the world with ballistic missiles. On the wings of stolen American F-22 and F-35 blueprints, China is also flying fifth-generation stealth fighters. And its bold reach for the stars–planning moon and Mars missions and a militarized space station–will increasingly bring the ultimate strategic high ground within Beijing’s reach.

This rise of Chinese militarism portends tectonic shifts—economic, geographic, and political. It also means investors will win or lose fortunes.

Key portfolio decisions will range from the pricing and hedging of geopolitical risk to asset allocations across continents and countries. Bold traders will initiate Soros-style exchange-rate bets in anticipation of conflict-driven currency moves. The most opportunistic will tactically buy and short company stocks and country index funds around major conflict flashpoints. These range from China’s “renegade province” of Taiwan and a nuclearized North Korea, to the resource-rich but dangerous waters of the East and South China Seas.

Looking Ahead

A more sophisticated understanding of geopolitical risk will be an investor’s best friend in a 21st century of authoritarian aggression. Billions have already changed hands since Russia’s Ukraine adventures began in 2014. As the ruble has plunged and partly rebounded, German and U.S. bond prices have gyrated with flights to safety, and volatile European bourses have alternated between fear of reduced trade and hope of peace. A simple anticipatory short on an index fund for the Russian market would have netted a nearly 50% gain.

It is an open question whether a rapidly militarizing China will follow in Russia’s determined footsteps. While some still argue (or hope) for a “peaceful rise,” former Chinese leader Deng Xiaoping’s admonition to “seek truth from facts” quickly leads to a forecast of significant conflict.

Like Russia’s Vladimir Putin, China’s Xi Jinping is aggressively pursuing historical territorial claims unsupported by modern international law. China asserts sovereignty over 80% of the South China Sea–one of the most strategic sea lines of communication, through which a third of all shipping flows.

From Shoals to Islands

To press its expansive claim, China sends flotillas of white-hulled coast guard and commercial fishing vessels backed up over the horizon by gray-hulled Chinese warships. Through such coercion, China has already sliced disputed shoals, petroleum reserves, and islands from the Philippines and Vietnam. Today, as the People’s Liberation Army builds heavily armed garrisons on artificial reefs supporting 10,000-foot runways, U.S. bombers and warships pass close in protest.

The East China Sea is similarly tense as Chinese ships routinely violate the territorial waters surrounding Japan’s Senkakus Islands. In nationalistic backlash, Japan’s electorate has chosen a prime minister remolding Japan’s constitution to facilitate remilitarization. Against this backdrop, the U.S. has publicly reasserted its commitment to defend Japanese territory. Beijing, Tokyo, and Washington could face a Sarajevo moment.

China’s long-running bid to take Taiwan likewise portends conflict: Much of China’s militarization has focused on low-cost “asymmetric weapons” like the DF-21D anti-ship ballistic missile explicitly designed to sink the high-cost capital assets of America’s aircraft-carrier strike groups. Would the next American president risk sending aircraft carriers to the Taiwan Strait as Bill Clinton did in defense of the island democracy in 1996?

Perhaps most dangerously, Chinese and American warships spar frequently over their dueling definitions of freedom of navigation. While the U.S. supports the internationally recognized 12-mile territorial limit, China insists on controlling commercial and military shipping as far as 200 miles from its coast. China’s threat to freedom of navigation must be a clear red line, as a 200-mile limit would constrain access of American commercial interests to some of the most lucrative markets in the world and effectively run the U.S. Navy out of the Asian side of the Pacific.

Defensive Investments

Any significant conflict in Asia would immediately damage the highly interconnected global supply chain and trading network, with all the negative implications for asset prices any such geopolitical shock might entail. The question for money managers is how to exploit tensions and conflicts.

The next several decades should be very bullish for defense industry stocks. Already, China’s aggressive behaviors have triggered an underwater arms race: Japan, South Korea, Vietnam, and even Indonesia are shopping for submarines.

In the face of both Russian and Chinese aggression—and against the backdrop of an emerging Putin-Xi axis—the 2016 presidential campaign will also feature repeated calls for building more ships, more submarines, more planes, and more elaborate air, missile, and cyberdefense systems. The prudent investor seeking magnified returns will follow the fundamentals and technicals of every publicly traded company involved in this potential construction boom.

While there may be a fine line between prudence and war profiteering, no investor should feel guilty about preparing for the contingencies of a Great Power conflict with China. This is a world in which the highest rates of return will be generated by investors and traders with the most sophisticated geopolitical awareness. Understanding the full range and scope of China’s militarism is where such awareness must begin. 

PETER NAVARRO is a professor at the Merage School of Business, University of California-Irvine. He is author of Crouching Tiger: What China’s Militarism Means for the World (Prometheus Books, crouchingtiger.net).

Editorial page editor Thomas G. Donlan receives e-mail at tg.donlan@barrons.com.