Japan Spooks Investors Over Potential Conflict With China

Although we don't believe in timing the market or panicking over politicians' utterances, we do like to keep an eye on potential risks -- just in case they're material to our investing thesis.

At the World Economic Forum on Wednesday, Japanese Prime Minister Shinzo Abe likened current relations between Japan and China to those between the U.K. and Germany in 1914, the year WWI broke out. The day before, according to Business Insider chief Henry Blodget, an "influential Chinese professional" told attendants at another talk why he thought military conflict with Japan was inevitable. While I'm not predicting WWIII, it's worth considering the possibility of a Japan-China military conflict and how business would be affected. Read on to find out more, and what this could mean for your investments.

The sentiment of U.S. investors on the possibility of a Japan-China war can best be summed up by what a business owner who sources all of his goods from China told me: "Everyone knows that won't happen; there's too much money at stake." But with the leader of Japan having made such an ominous statement, investors shouldn't bury their heads in the sand. According to Gideon Rachman, chief foreign affairs commentator for the Financial Times, Abe went on to elaborate his thinking. Rachman writes: "The comparison ... lies in the fact that Britain and Germany -- like China and Japan -- had a strong trading relationship. But in 1914, this had not prevented strategic tensions leading to the outbreak of conflict."

He went on to say that any "inadvertent" conflict would be a disaster, and that there should be a military-to-military line between the two countries. The BBC notes that in the interview, Abe says:

  • The 10% annual increase in China's defense budget is a provocation.
  • China is wrong to view his visit to the Yasukuni shrine as honoring war criminals.
  • Japan's title to the Senkaku Islands is unimpeachable.

The Senkaku Islands are a collection of uninhabited, bombed-out rocks in the South China Sea, which Japan has controlled since 1895, but which China lays claim to. Tensions have been high in the Pacific, as China claims the entire South China Sea and disputes who owns what in the East China Sea.

Source: Wikimedia Commons.

Tensions rose on Nov. 23 when China announced a new "air defense identification zone" that includes the Senkaku Islands. In response, three days later, the U.S. flew two B-52 bombers over the islands. The U.S. has a mutual defense pact with Japan and maintains 38,000 personnel in Japan under the U.S.-Japan Treaty of Mutual Cooperation and Security of 1960, so the U.S. is required to respond to any attack against Japan. Other key allies of Japan include Australia, which in 2007 signed the bilateral Joint Declaration on Security Cooperation. This is not a mutual defense pact, but it does say the two countries will cooperate on border security, among other areas.

Trade
If something were to happen and trade with China stopped temporarily, businesses worldwide would be hurt, as the world's supply chains are reliant on trade with China. It would be terrible for the consumer electronics sector, as the industry has moved a great deal of its manufacturing operations to China. Apple (NASDAQ: AAPL  ) is a poster child of this, with its suppliers including Cirrus Logic (NASDAQ: CRUS  ) , Broadcom (NASDAQ: BRCM  ) , and others with significant operations in China.

Take the iPhone for example. Ninety percent of the rare earths for parts like the screen, circuitry, speakers, and vibration unit require rare earths from China, particularly its Inner Mongolia region. While most of the manufacturing of specialty parts happens elsewhere, including Korea, Germany, Taiwan, and Japan, a significant portion is still sourced from China. A report on the iPhone supply chain from FinancesOnline estimated that Apple had 330 suppliers in China, more than Japan, Korea, and the U.S. combined. To top it off, nearly all of the iPhones are assembled in China and Taiwan by Foxconn.

A stop in trade would also be terrible for Australia, which is undergoing a housing-market boom on the back of China's demand for iron ore and coal. BHP Billiton (NYSE: BHP  ) and Rio Tinto (NYSE: RIO  ) have been some of the biggest beneficiaries of China's rise, and would be hardest-hit. BHP Billiton gets 29% of its revenue from China, while Rio Tinto gets 35% from China. It would also be terrible for Caterpillar (NYSE: CAT  ) , which has benefited significantly from a commodity boom along with the major miners.

Foolish bottom line
In talking about his successor, Warren Buffett has said he or she would need to be able to "see around corners" and be "wired to detect risks." The probability of a China-Japan war is low, but the impact would be large. While we can't know the future for sure, it's good to follow the Boy Scout motto of "be prepared." Let's hope for the best, but be prepared for the worst.

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