How We Are Preparing For SPY’s Top Geopolitical Risk In 2023

Evidence is mounting that points to a potential Chinese invasion of Taiwan as soon as 2023. The headlines are routinely filled with reports of increasing Chinese aggression toward the island nation, and China’s military buildup has been nothing short of stunning. In recent weeks it has caught the attention of and heightened concerns among NATO members, prompted Japan to announce plans to double its military spending, and featuring increasingly prominently in wargaming scenarios and exercises in both sovereign defense planning as well as in think tank brainstorming.

All of this follows a quote from the top U.S. Admiral just a few months ago, where he said that a Chinese invasion of Taiwan could very possibly happen sometime in 2022-2023:

When we talk about the 2027 window, in my mind, that has to be a 2022 window or potentially a 2023 window.

This announcement – from someone with access to perhaps the best intelligence and research on the issue outside of Communist China – should be alarming to everyone, especially investors. It also further confirms our view that – while there are numerous macro risks right now – the biggest threat to global prosperity and future gains in the stock market (NYSEARCA:SPY) as we head into 2023 is a potential Communist Chinese invasion of Taiwan. With China sending scores of planes and numerous ships into Taiwanese territory on a regular basis – including 71 warplanes and seven ships in the past 24 hours alone – and with increasing frequency, the risk of a war breaking out is very material.

In this article, we will discuss the possible ramifications of a possible Chinese invasion of Taiwan and then discuss our approach to our portfolio in light of this risk as we head into 2023.

How A Chinese Invasion Of Taiwan Will Impact SPY

In the catastrophic scenario where China launched a full-scale invasion of Taiwan, global markets – including SPY – would likely crash in the immediate aftermath.

Obviously, Chinese stocks would crash due to the expectation of sanctions on China from the global community (similar to what happened to Russia after it sent its troops into Ukraine) as well as the threat that the Communist Chinese Party would seize control of many of China’s companies, or at the very least those of their resources that it deemed essential to the war effort.

However, global markets also would crash due to four major factors:

1. Fear that additional major economic powers such as the United States, South Korea, Japan, and Australia would become directly involved in the conflict, combining with sanctions to result in major disruptions in global trade and supply chains.
2. On top of this, if the United States and its Pacific allies enter the conflict on behalf of Taiwan and the battle over the island’s fate spreads throughout the region with use of force escalating between the two sides, there is a very real possibility that World War 3 begins.
3. Taiwan produces a healthy majority of the world’s semiconductor chips and nearly all of its advanced ones, making a war on the island enormously disruptive to the technology industry and really any company that depends on these chips. This disruption alone could plunge the world into a recession, if not a depression.
4. Finally, many mega-cap U.S. stocks have significant exposure to China, depending on it for both a substantial portion of their production but also sales. Some obvious examples of this include Apple (AAPL) and Tesla (TSLA). If war and corresponding sanctions break out in the region, both of these companies – which combine to make up over 8% of SPY – would suffer severe losses and disruptions to their businesses. Add to that the countless other companies in the index that have significant direct or secondary exposure to China, and the SPY is guaranteed to not only see a short-term panic-driven sell-off but likely a more long-term destruction of intrinsic value as well.

Some estimate that the global economy could suffer a staggering $2.6 trillion loss in the immediate aftermath of a Chinese invasion of Taiwan, with more serious losses following in a protracted conflict. Even a U.S. government official (the Commerce Secretary) believes that the disruption of the Taiwanese semiconductor supply chain would inflict serious economic pain on the United States:

If you allow yourself to think about a scenario where the United States no longer had access to the chips currently being made in Taiwan, it’s a scary scenario. It’s a deep and immediate recession.

The RAND Corporation quantified this with estimates that put a 5% decline in U.S. GDP from such a conflict. For perspective, this number is almost twice the decline suffered in the wake of the Great Financial Crisis.

Our Approach

The historically elevated black swan risk that we face today – spearheaded by the threat of a Chinese invasion of Taiwan – means that the risk-reward for SPY is increasingly unfavorable, even after a year of poor performance.

Not only would a potential escalation in the Taiwan Straits be harmful and even devastating to SPY, but the economy is increasingly likely headed for a recession in 2023 and the current valuation of SPY based on numerous models reveals that the market is currently between fairly valued and slightly overvalued. As a result, we see more downside risk than upside potential in SPY at the moment.

That said, however, we’re not entirely avoiding the markets today. At High Yield Investor, we continue to maintain a healthy allocation to businesses that profit from uncertainty, soaring risk, and volatility. In particular, these include our current holdings like Barrick Gold (GOLD), Newmont Corporation (NEM), and Virtu Financial (VIRT). Put another way, we believe that there’s a very bullish setup for precious metals heading into 2023 and beyond and also believe that VIRT – as an asset-light business that benefits from volatility spikes, is buying back shares hand over fist, and paying out a nice dividend – currently offers extremely attractively asymmetric risk-reward for investors.

We also maintain a healthy allocation to U.S. energy infrastructure (XLE), U.S.-based defensive REITs (VNQ) and utilities (XLU), and some opportunistically priced investment grade fixed income investments that should all outperform the broader market in the event of such a negative scenario playing out.

As a result, my investment allocation looks approximately like this at the moment:

Investor Takeaway

The risks of World War 3 – or at the very least a major regional conflict in the Asia-Pacific region – breaking out have never been higher since the Cold War ended. On top of that, the global economy appears destined for a recession in 2023 and perhaps beyond. Meanwhile, SPY remains fairly to slightly overvalued based on many popular models. As a result, we’re neutral on SPY at the moment and have no shares of the index in our portfolio.

With that said, we don’t shy away from market volatility and are not market timers. In fact, we embrace volatility and uncertainty because it provides us with compelling bargains and better opportunities to outperform the broader market. We also maintain a longer-term time frame in our approach to investments. As Warren Buffett says:

if you don’t feel comfortable owning a stock for 10 years, you shouldn’t own it for 10 minutes

He has also told investors in the past that:

There is simply no telling how far stocks can fall in a short period… The light at any time can go from green to red without pausing at yellow.

Over the course of its illustrious history under Warren Buffett, Berkshire stock (BRK.A) (BRK.B) has seen its stock plunge five separate times:

• down 59% in 1973-1975
• down 37% in 1987
• down 49% in 1998-2000
• down 51% in 2008-2009
• down 26% in 2020

Of course, we don’t have a crystal ball and cannot know for sure how the stock market will perform in the short run, but historically, those who have had the courage to buy stocks when they were temporarily discounted have always been richly rewarded in the following years.

As a result, our approach moving forward will continue to be the same as what it has been: Instead of fretting about short-term performance, we will keep our focus on the passive income that our portfolio is generating in the short term as well as a five-year time horizon for total return generation. With this mindset, we’re able to sleep soundly at night, stay calm during the day, think rationally, take advantage of bargains that the market indiscriminately throws at us by making consistent small additions to our portfolio whenever capital becomes available (from a combination of dividends, opportunistic capital recycling, and additional cash flow from investments external to our portfolios), and ultimately build our passive income stream.

Over the long term, we look forward to the outperformance that will be generated by our investments made today that we purchased from others who are panic selling. As Warren Buffett once said:

Games are won by players who focus on the field, not the ones looking at the scoreboard.

Instead of focusing on the stock prices being thrown at us each day, let’s keep our focus on the true intrinsic value that our businesses are compounding for us.

By prudently diversifying our long-term general investments with complementary positions in more defensive positions as well as those that are poised to profit from soaring geopolitical risks, we believe we can achieve alpha in the current environment without abandoning the long-term bullish on America thesis underpinning our core strategy.