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Carrots and Sticks in Taiwan

May 15, 2019 | Multi-Asset

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In Asia, much of the spotlight has been on the interplay between North Korea, China, and the United States—but that may be shifting as Taiwan's elections approach. And that is creating potential headwinds and tailwinds we'll need to monitor.

The Key Issue: Independence vs. Reunification

We analyze multiple game theaters across the globe to better understand potential investment implications from macro developments, so I spent some time in Taiwan on a research trip this spring to better understand how Taiwan fits into our Asia security and trade-oriented game theater.

As I explained in a previous post, China sees Taiwan as a breakaway province and would like it to be part of the mainland, but Taiwan wants independence. And the various shades of gray to that mega-institutional question will soon be on display as primaries for Taiwan's January presidential election get underway.

The effect on our Asia game theater and, thus, our portfolios is the direction and magnitude of change of the low probability but potentially large tail risk of Taiwanese sovereignty becoming a question.

In the last election, which took place in 2016, a significant change occurred: The mainland-friendly Kuomintang party (KMT) was defeated by Tsai Ing-wen of the more populist Democratic Progressive Party (DPP). That spurred a response from China, which demanded that the U.S. Congress back off new laws that would strengthen the U.S. relationship with Taiwan.

And since then, it seems there has been a marginal shift away from independence. A long-running Election Study Center survey has asked Taiwanese voters how they feel about independence vs. unification. While the wide majority favors “status quo,” there has been an uptick in “move toward unification.”

Both sides have considered time as being on their side. The mainland thinks, “As time goes on, we'll get bigger, and it will be natural for Taiwan to be a part of us.” And Taiwan thinks, “As time goes on, we'll become increasingly more sovereign and less connected to China.”

New Elections, New Possibilities

But that may change, with all eyes once again on Taiwan as elections approach. Will the candidate who wins the 2020 election favor or frown upon unification, and how will that candidate be treated by Beijing and the United States?

The incumbent, President Tsai Ing-wen, is running again in the DPP primaries, and the incumbent is rarely challenged—but that is not the case this time. Taiwan's former premier, the pro-independence William Lai, will challenge her.

A number of candidates are also running or likely to run in the primaries for the KMT: Eric Chu, incumbent mayor of New Taipei, who ran against Tsai in 2016 and lost; Terry Gou, the Taiwanese tycoon who is the founder of Foxconn, the world’s largest contract manufacturer of electronics; and Han Kuo-yu, mayor of Kaohsiung—an area the DPP usually wins. Beijing has already offered some agricultural deals to Han, so he seems to be, at the other extreme, Beijing's preferred candidate.

Lastly, Taipei City mayor Ko Wen-je may also run, perhaps as an independent.

Currently, it looks like the KMT has the momentum. Late last year, the KMT significantly outperformed the DPP in local elections, which are litmus tests for the upcoming national elections. But a lot can happen between now and January—and we're keeping an eye on what many think of as a trend toward anti-establishment sentiment. Such sentiment has been increasing since around 2011, with less direct party association and more draw to the cult of personality.

Key Risks

The effect on our Asia game theater and, thus, our portfolios is the direction and magnitude of change of the low probability but potentially large tail risk of Taiwanese sovereignty becoming a question.

The tail risk will fall if China's favored candidates are more popular with Taiwanese voters. If that's the case, we may see Beijing extend some carrots toward its relationship with Taiwan (like the agricultural deals it offered Han). That could be a short-term positive for Taiwan, removing some tail risk.

But that scenario could flip, for example, if Lai wins the primary for the DPP. In this case, China would be very uncomfortable. In the past, it has tried to influence the head of the election with threats (which typically have the opposite of the intended effect). We could also see China run some ships through the Taiwan Strait. These moves are more symbolic than impactful, however.

The United States is the other player in this game theater. The U.S. Navy sailed warships through the Taiwan Strait on April 28, a move the U.S. Navy said demonstrated a commitment to a free and open Indo-Pacific.

That marks at least seven times in about eight months the United States has sailed through the international waterway that separates Taiwan from China. Before that, such operations were considered relatively rare, occurring at a pace of about once a year.

And these moves are angering China. “The Taiwan issue is the most important and sensitive issue in Sino-U.S. relations,” said Chinese Foreign Ministry Spokesperson Geng Shuang.

Portfolio Implications

We begin by determining long-term fundamental value and then monitor potential headwinds and tailwinds that may influence the direction of prices either away from or toward fundamental value. Currently, our portfolio exposure is flat to Taiwan equity and short to the Taiwan dollar (TWD), but these exposures may change as we get more information on the primaries.

Aaron Balsam, CFA, is a senior analyst on William Blair's Dynamic Allocation Strategies team.