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Takeaway: War is unlikely, but election outcomes and economic growth are certainly at risk in both countries.

Over the last few weeks, there have been daily protests in China against Japan over territory in the South China Sea. Over 500 protests have occurred daily with the Chinese government rarely interfering, which is odd in the sense that the government is usually keen to keep demonstrations of this sort on lock down. The questions that outsides looking in have been asking are: what’s going to happen? Will the two countries undergo a trade war or a military conflict?

Military action is an unlikely scenario; both sides have too much to lose and are too interdependent on one another. That said, however, our Macro team believes that as the territorial dispute drags on, economic growth is potentially at risk as trade protectionism kicks in and sentiment becomes depressed. With the militaristic undertones of current policymakers on both sides in full swing, the conflict is unlikely to be resolved soon.

Hedgeye Senior Analyst Darius Dale brings to light what could happen as we head into 2013:

Both China and Japan have leadership transitions/parliamentary elections on the docket in 2013, so it would seem that maintaining a strong geopolitical face is in the interest of policymakers in both countries. Leaders who engage in defending the sovereignty of their nation tend to resonate well with their respective populace.”