How worried should traders be about Pelosi’s visit to Taiwan?

So far this week, safe-haven flows have been the market theme. The yen strengthened considerably and the Nikkei fell. US stocks were down on the first day of trading. Of course, other factors affect market sentiment, but obviously geopolitics also plays its part. Currencies could be very volatile over the next few days.

The first part is the drop in risk appetite that we are already seeing. Once the event is resolved, there could be a reversal of these flows and a rebound in the markets. So keeping track of what’s going on can give a good insight into what’s going to happen in reverse over the latter part of the week.

What is the problem ?

U.S. House of Representatives Speaker Nancy Pelosi is expected to arrive in Taiwan later today and meet with the country’s president early tomorrow. Both are on Taiwanese time, so it would be all night for European and American traders. Pelosi would be the highest-ranking US official to visit the disputed island in 25 years, making it a symbolically significant event.

Notice how this was all written in conditional tens? There is no official confirmation that the visit will take place. Pelosi herself tweeted her itinerary earlier in the week and did not include Taiwan. China is very unhappy with this visit and has threatened to retaliate. Worryingly, among the potential retaliation measures are “military” options. The Global Times editor, who is believed to represent the Chinese government, tweeted earlier in the day, stressing that military retaliation was likely.

But what does that mean?

Despite the dismay of the press, the real actions seen as real possibilities are generally seen as more symbolic – like the visit. China already conducts lifelong shooting drills in the South China Sea. There were reports that they could fire bullets into the Taiwan Strait, something that hadn’t happened since 1995.

The concrete measures that could impact the markets should be more discreet. China yesterday banned food imports from more than 100 Taiwanese companies in a move seen as retaliation for hosting the US House speaker.

So why all the consternation?

Shares of Taiwan Semi fell significantly ahead of the visit as Taiwan’s semiconductor industry is seen as the key issue. Fleas are rare, despite nearly two years of efforts to increase production worldwide. Any possible interruption in the supply of semiconductors should worry investors.

But the bottom line is that markets don’t like uncertainty, and either outcome of the visit could have important implications. If Pelosi pulls off the visit, which is the most likely scenario, retaliatory measures from China will have to be considered. If Pelosi does not leave (and there is still no official confirmation), it could be seen as a retreat from the United States in the face of Chinese pressure, and it could change the geopolitical situation.

Taiwan is the final leg of Pelosi’s trip to Southeast Asia, and she is expected to return to Washington on Thursday. Then we will know how it will all turn out. In the meantime, risk aversion could be the major theme of the markets, especially those exposed to Asia.

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