Portfolio Preparation After Four-Star General Warns Of War With China

Summary

• A recently leaked memo from a U.S. Air Force four-star General indicates that the U.S. and China could likely be at war in 2025.
• We discuss the potential ramifications of such a scenario on the global economy and stock market.
• We also share our top pick to buy today to prepare your portfolio for a war between the world's two largest economies.
• Looking for a portfolio of ideas like this one? Members of High Yield Investor get exclusive access to our subscriber-only portfolios. Learn More »

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A recently leaked memo from a U.S. Air Force four-star General indicates that the U.S. and China could likely be at war in 2025. In this article we will discuss the potential ramifications of such a scenario on the global economy and stock market. We also share our top pick to buy today to prepare your portfolio for a war between the world's two largest economies.

The Leaked Memo

A memo from four-star U.S. Air Force General Michael Minihan scheduled for release on February 1st, 2023 was leaked ahead of time. In it he addresses his command, stating:

I hope I am wrong … (but) my gut tells me we will fight in 2025

He went on to state that the 2024 presidential elections in Taiwan and the United States would likely provide enough division and distraction in those countries to create ripe conditions for the Communist Chinese to launch an invasion of Taiwan. He also instructed his soldiers to train for war with a focus on "unrepentant lethality" and said that they should have their personal affairs in order and be prepared for conflict by March.

Stock Market Ramifications Of A U.S. - China War

General Minihan's remarks echo similar remarks made by high-level officials recently. These include a leading Republican Congressman and Chairman of the Foreign Affairs Committee - Michael McCaul - who agreed with General Minihan's assessment and said that he thinks the odds of conflict with China over Taiwan are "very high." The U.S. Navy's top Admiral said last fall that a Chinese invasion of Taiwan is potentially imminent:

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

On the other hand, the Pentagon stated that General Minihan's statements are

not representative of the department’s view on China.

Furthermore, Defense Secretary Austin stated that he seriously doubts that a Chinese invasion of Taiwan is imminent. Perhaps unsurprisingly, the leading Democrat on the House Armed Services Committee - Representative Adam Smith - disagreed with General Minihan’s and Congressman's McCaul's assessment of the situation, stating:

not only not inevitable, it is highly unlikely.

While one memo from a four star general is not indicative of the official opinion of the Department of Defense and is certainly not a guarantor that war between the U.S. and China will break out, it should not be ignored either. This is particularly true given that there are clearly several other high level officials with access to classified intelligence who agree with him.

If such an apocalyptic scenario were to come to fruition, the results for the stock market would be catastrophic. Without a doubt, the major indexes like the S&P 500 (SPY)(VOO), the Dow Jones (DIA), and the Nasdaq (QQQ) would all crash. Furthermore, several leading U.S. companies like Apple (AAPL) and Tesla (TSLA) would suffer immensely due to their large dependence on China for both production and consumption of their products.

With the U.S. and China occupying the top two spots in the global economic rankings and the world's third largest economy - Japan - also likely to become embroiled in the conflict, a global depression is almost a near certainty. On top of that, Taiwan produces the majority of the world's semiconductor chips with giants like Taiwan Semiconductor Manufacturing Company (TSM) based there. If the global flow of semiconductors gets disrupted, the global economy - especially the technology industry - will come to a screeching halt.

Estimates put the immediate global economic damage of such a conflict in the trillions of dollars, with losses becoming even larger over the course of a prolonged conflict. The U.S. Commerce Secretary predicted "a deep and immediate recession" in the event of a Chinese invasion of Taiwan. Meanwhile, the highly respected RAND Corporation estimated that the U.S. economy would suffer a GDP decline that doubles that seen during the recession following the financial crisis of 2008.

Our Top Picks

Given that the likelihood of China invading Taiwan in the next few years is incredibly hard to handicap, in our view, it is not prudent to try to time the market by completely leaving equities. At the same time, however, the odds are high enough that it would be naive, if not reckless, to completely ignore the possibility of such a scenario occurring.

First and foremost, if you need a substantial amount of cash in the next year or two, it would probably be prudent to keep that amount out of the stock market. This is especially true since interest rates are quite attractive right now on CDs and similar short-term cash-denominated investments.

Furthermore, even within your equity allocation it would probably be prudent to have some investments that are likely to outperform in a dramatic risk-on scenario like that.

As a result, at High Yield Investor we are building our portfolio to overweight blue chip gold miners (GDX) such as Barrick Gold (GOLD) and Newmont Corporation (NEM) since a flight to safety will likely boost gold's (GLD) prospects in the aftermath of such a conflict breaking out. Furthermore, we are buying shares of market-maker Virtu Financial (VIRT) hand-over-fist right now.

We are so bullish on it - especially when weighing the risks posed by a potential China invasion of Taiwan - VIRT typically sees its profits soar and its stock massively outperform during periods where volatility (VIX) spikes. In the case of 2020, VIRT stock soared 60% higher even as the S&P 500 pulled back sharply. In the 2008 stock market crash, VIRT saw its profits soar too (it was privately held at the time, so there is no stock performance to track there).

On top of that, now is probably the best time ever to buy VIRT because there are growing risks of black swan events (in both the financial system - due to rising interest rates and weakening economic conditions - as well as geopolitically due to the aforementioned conditions in the Taiwan Straight) and VIRT's valuation is at dirt-cheap levels. The company continues to buy back shares hand-over-fist while also paying out a dividend that is very well-covered by earnings and now yields ~5%.

As you can see from the chart below, VIRT's earnings generally increase with volatility, its share count is declining rapidly, its dividend is well-covered by earnings per share even during periods with low volatility, and the returns on capital for the business are enormous:

VIRT Investor Presentation

As a result, regardless of whether or not a Chinese invasion of Taiwan comes to fruition in the near-term, we expect VIRT to generate very attractive total returns for shareholders moving forward due to a combination of aggressive share buybacks, high returning organic growth initiatives, valuation multiple expansion, and the attractive and safe 5% current dividend yield.

Investor Takeaway

China's belligerence towards Taiwan continues to increase, as does the CCP's capacity and apparent will to use force to bring the island nation under its oppressive thumb.

Meanwhile, there is disagreement within the highest levels of the U.S. defense and intelligence communities as to whether or not China will actually take violent action towards Taiwan within the next few years.

Given the apocalyptic-type ramifications of such a scenario playing out, investors would be prudent to not totally ignore those who believe a Chinese invasion is more likely than not within the next few years. At High Yield Investor, we are positioning our equity portfolio for such a scenario by loading up on gold miners and VIRT, which is likely to profit richly from a sudden market crash in the wake of a Chinese invasion.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of GLD, GOLD, NEM, VIRT either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.