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Takeaway: International protectionism is poised to meaningfully accelerate over the intermediate term.

SUMMARY BULLETS:

  • While we view the threat of military intervention as highly improbable, we do think the heightened tension over the Senkaku (Japan)/Diaoyu (China) islands risks facilitating a string of international protectionism – which is already poised to accelerate due to recent political promises out of the Obama and Romney camps.
  • Such protectionism would have dire economic effects globally, with Japanese industrial production and US/EU consumption getting hurt the most – the former due to lower Chinese demand; the latter due to higher import price inflation.
  • Retaliatory measures, while not an acute risk, could beget broader financial market and economic contagion globally. This is a meaningful TAIL risk, given the recent rhetoric and maneuvers of international policymakers.

In recent days and weeks, the geopolitical tensions surrounding China and Japan’s territorial dispute over the Senkaku (Japan)/Diaoyu (China) islands have certainly elevated to a critical level. Currently, outraged citizens across ~85 cities in China are protesting Japanese occupation of what is viewed by the Chinese as their sovereign territory, physically damaging Japanese businesses in the process. To some extent, a fair amount of yesterday’s social unrest was a function of yesterday being the anniversary of the commencement of Japan’s 1931 occupation of China. That being said, however, the situation remains far from resolved. In fact, it appears poised to get a lot worse before it is ultimately resolved.

As a quick refresher, the following link (albeit from the Tokyo governor’s office) details the size, location and the highly controversial geopolitical history of the disputed territories, which lie squarely in the East China Sea: http://www.chijihon.metro.tokyo.jp/senkaku_english.htm. Interestingly, an LDP victory in Japan’s parliamentary elections (due by AUG ’13) will all-but-guarantee this territorial dispute is not resolved efficiently, as all three candidates to replace Sadakazu Tanigaki as the head of the LDP are in favor of Japan’s attempt to nationalize and develop the islands (as are 75% of Japanese voters). It's worth noting that the LDP is currently favored in polls vs. the ruling DPJ by a margin of 31% to 14%.

ARE CHINA AND JAPAN HEADING FOR WAR? - 1

On the topic of conflict resolution, US Defense Secretary Leon Panetta visited China yesterday (after visiting Japan the day prior) attempting to help mediate the dispute, which comes in the wake of the recent attempt by Japan to nationalize the islands and a recent Chinese sovereign declaration of precise boundaries for the waters surrounding the islands – an act that may lead to heightened pressure to respond with military force if a Japanese vessel invades China’s “sovereign” territory. It is our view that the US would ultimately be forced to side with Japan in the event of a military conflict, given its current use of Japan as a key military base in the region – highlighted by a deal Monday for the US to build a brand-new, anti-missile radar shied on Japanese soil. For now at least, the threat of military intervention remains low.

A threat that is not improbable at the current juncture is large-scale protectionism on the international trade front. Combining their bilateral exports, China and Japan shipped each other $316.1 billion of goods last year  – which would rank their exchange of merchandise as the 34th largest country in the world! More importantly, their economic ties are even more interconnected, given the bilateral exchange of services, foreign and portfolio direct investment, as well as tourism flows. While total dollars are hard to quantify, the key takeaway here is that China and Japan are economically joined at the hip.

Japan, however, is a bit more economically joined at the hip to China than China is to it. In fact on an aggregate basis, Japan relies on Chinese demand 2.5x the rate China relies on it (China-to-Japan = $148.5B or 7.8% of total exports; Japan-to-China = $167.6B or 19.7% of total exports). Moreover, key retailers in Japan look to Chinese end markets for a meaningful portion of their global sales (Nissan at 26%, followed by Honda at 20%) and Fitch Ratings has already threatened to downgrade a host of Japanese companies should the geopolitical dispute drag on. In short, a Japan-China trade war would most likely be more impactful to the Japanese economy than it would be to the Chinese economy – especially considering that the former is more reliant on international demand for growth amid a 20yr-plus economic malaise.

Even beyond end-market protectionism, such as economically-punitive tariffs, China could enact rather destructive measures on Japanese (and global) supply chains by choking off its production and shipment of rare earths – a critical input in just about every modern piece of technological equipment, ranging from cell phones to computers to televisions to light bulbs to missiles. China, which is home to over 90% of the world’s rare earth supplies and 23% of global reserves, has already signaled that its reserves are declining and have recently commenced a round(s) of strategic buying to boost stockpiles and protect the industry from overexploitation.

To be fair to China, this latest measure is in line with their three-year trend of systematically reducing international shipments and production quotas, with a -20% production cut as recently as this AUG. To the extent this trend is accelerated in the name of protectionism, we would not be surprised to see fears of a rare earths shortage develop across the international markets. Keep an eye on the Market Vectors Rare Earths/Strategic Metals ETF (REMX) for signs of this risk; in fact, it could serve as a potential hedge for anyone with international tech exposure in their portfolio (SNE? AAPL?), as those companies would be at risk of margin erosion, on the margin. On the flip side, any potential input cost increases could be passed through to international consumers, which would likely slow consumption growth broadly. How much someone in the US or Spain can afford to pay for an iPhone 5 remains to be seen…

ARE CHINA AND JAPAN HEADING FOR WAR? - 2

Jumping ship, we briefly wanted to touch on what we see as growing risk that the US and China are headed down a similar path of protectionism, as China’s manufacturing prowess at the expense of the US laborer has become an increasingly hot topic on the US presidential election campaign trail. To that tune, President Obama and Presidential hopeful Mitt Romney exchanged rhetorical blows earlier in the week on the US’s bilateral trade with China. While both candidates appear to be blowing a fair amount of political smoke, we’d be remiss to ignore their aggressive tone towards China and any potential implications of tighter US trade policy towards the Asian manufacturing giant.

Per Bloomberg: “The economy returned to the forefront of the presidential campaign as the U.S. today filed a challenge at the World Trade Organization accusing China of illegally subsidizing exports of automobiles and auto parts. It was the administration’s second complaint related to the auto industry since Obama began his re- election campaign. The aid amounted to at least $1 billion between 2009 and 2011 and benefited as much as 60 percent of Chinese car-parts exports, according to the U.S. The subsidies put U.S. component manufacturers at a competitive disadvantage, which encourages the outsourcing of car-parts production to China, the U.S. said. The U.S. announced the complaint 50 days before the Nov. 6 presidential election and 15 days before early voting starts in Ohio. The state has 54,200 residents employed by the car-parts industry and 12.4 percent of the state’s total employment related to the auto sector.”

From our purview, Obama is clearly elevating China’s “unfair” trade policies on his political agenda – likely to dodge pre-election heat from pro-business supporters that claim he hasn’t done enough during his first term in office to protect American corporations from having to outsource labor costs in order to remain competitive. As it stands, we anticipate that a large portion of Obama’s tough talk will die down after the election (assuming his likely victory); conversely, a Romney victory would accelerate protectionist measures aimed at unwinding China’s competitive advantages, given his repeated claim to label China as a currency manipulator (and thereby invoking highly-punitive measures against China) on his first day in office.

In the short-run, meaningful anti-China trade measures are likely to lead to higher US consumer and producer price inflation, as increased cross-border transactional costs get passed through to US consumers and businesses. To the extent China retaliates with measures of its own, we could see US businesses like YUM and NKE that have a large [and growing] Chinese footprint suffer on their respective top-lines.

Stay tuned – as if the next 3-6 months weren’t going to be eventful enough!

Darius Dale

Senior Analyst