In the Why stage of our investment process, to understand the influences outside of fundamentals that impact prices of markets and currencies in the short- to medium-term, we borrow from game theory to help us get as much understanding of geopolitical situations into our investment decisions as possible. A long-standing, multi-player negotiation across both trade and security involves Asian countries as well as the United States. These negotiations have become intense enough for us to formally construct a game theater focused on Asia.
Within this game theory framework, we identify the major players, their objectives, and the powers they may wield to achieve these objectives. The goal is not necessarily to predict outcomes, but to understand and not be surprised by actions and reactions as negotiations develop. This helps us navigate short-term headwinds or tailwinds to the fundamental opportunities coming from the Where stage of our process.
Trade and Security Tensions Building
In a very interconnected region, two prominent, recent trade deals feature several Asian countries. The Trans-Pacific Partnership (TPP) includes several Asian countries but excludes both China and the United States, now that President Trump has formally withdrawn the U.S.’s consideration of the agreement. We’ve also been following the Regional Comprehensive Economic Partnership (RCEP), which also features several Asian countries, including China, but again excluding the U.S.
There is also the potential for a larger, longer-term deal such as the Free Trade Area of the Asia Pacific (FTAAP), which would be broader (including China, U.S. and some other countries) and that could potentially absorb or replace TPP and RCEP.
Security issues in the Asian theater feature long-standing military alliances that in many cases focus on navigation of the seas. Currently, competing claims on islands in the East and South China Seas create macro risks because these seas represent security posts, physical shipping lanes, and claims on potential untapped natural resources.
Beyond the seas, in response to North Korea’s aggressive stance, the U.S. reiterated its commitment to deploy the Terminal High Altitude Area Defense System (THAAD)—a missile defense system off the coast of South Korea—later this year, despite China’s strong opposition.
Interestingly, these trade and security issues often get intertwined in the negotiations. For example, the U.S. administration could potentially use security-related issues to ultimately negotiate trade deals across the region.
Who Are the Influential Players?
Our game theory analysis focuses on the six players with the greatest current influence. Other peripheral players, such as India, Philippines, Malaysia, and Australia, may also benefit from trade deals as well as from being out of the immediate crosshairs of some of the more prominent players.
We view the six influential players in three tiers:
- Tier 1—China and U.S.: I refer to these countries as “the heavies,” as they stand head and shoulders above the others in terms of their influence
- Tier 2—Japan and South Korea: They are somewhere in the middle in terms of influence
- Tier 3—Taiwan and Vietnam: They act a bit like small houses on a big block in that they’re able to benefit when the big influencers—China and the U.S.—are both bidding for them. But they can also be harmed if the top players use them to make a point.
We assess all players’ net influence based on four characteristics—endowment power, coalition power, risk tolerance, and salience—to help us determine their ability to influence negotiations. The chart below shows the current powers we attributed to the key players. Again, these geopolitical developments and related negotiations may drive the price of an investment toward or away from its fundamental value.
While the new U.S. administration’s policies are still taking shape, we believe the United States’ objectives are to impose more consistent enforcement of trade rules and to establish a narrower, but more robust set of security commitments.
The U.S. benefits from a broader, multi-lateral set of coalition partners as well as very high endowment power, given the demand for goods and the leverage it has through naval technologies. The new administration shows a greater degree of risk tolerance than the U.S. previously exhibited in this region.
China’s primary objective is to project stability and global leadership, expanding their strategic influence, especially ahead of the National Congress of the Communist Party of China meeting this fall.
Given China’s long-term perspective, their endowment power is likely to increase if unchecked. But they tend to act more unilaterally instead of via coalitions. In addition, China’s salience and risk tolerance are the highest in the region, despite their desire for stability.
Key Broad Implications
- China and the United States will be jockeying for coalition partners, using carrots and sticks related to trade and security issues
- The larger risk, albeit with a lower probability, is that the two dominant players will escalate their use of sticks against each other
- Another potential risk is that one of the less influential players (South Korea, Taiwan, or others in the region) does something to prompt a strong response from the U.S. or China
- Despite some potential sabre-rattling initially by the U.S., we don’t expect meaningful escalations this year as a result of China’s desire to pursue stability
- Japan has an opportunistic role as a result of Japanese Prime Minister Shinzo Abe pushing for constitutional reform to beef up security and military influence
Investment Implications: Winner + Losers
- We believe that Vietnamese, Philippine, and Malaysian markets and currencies will benefit from the current jockeying strategy of China and the U.S.
- At the same time, we believe South Korean and Taiwan markets and currencies are more at risk from this same jockeying
- Japan potentially benefits from sustained Abe leadership and the flexibility to pursue multi-country trade deals with either dominant power
- The theater’s influence on China and the U.S. is neutral—perhaps a slight positive for the Chinese yuan in the near term, and a medium-term risk for the U.S. IT sector
Our current currency positioning in our portfolio aligns with this geopolitical analysis. We’re long Asian currencies, such as the Chinese yuan, Philippine peso, and Vietnamese dong, and we’re slightly short the Taiwan dollar and flat the South Korean won.
On the market side, our bias in most instances is to be long Asian equity markets. We’re long—and above fundamental valuation signals—in Vietnam, China, Taiwan, and India. And, we’re long—but below fundamental signal—in South Korea. We are currently short both the Japanese equity market and the Japanese yen, in line with signals.
We will continue to monitor the key Asian players’ powers, communications, and actions to help determine the potential investment risks and opportunities.