IAUM - Gold May Skyrocket If China Actually Invades Taiwan

2023-09-14 14:09:51 ET

Summary

• Spiking implied lease rates since the end of August are highlighting a tight physical gold market, backed by record central bank purchases.
• Chinese gold demand may increase markedly into 2024 if planning an attack on Taiwan, a way to support its currency during a likely period of western economic sanctions in retaliation.
• The bottom line is some of China's uniquely massive $3.25 trillion in foreign currency reserves could quickly be exchanged for gold, launching its price.

Perhaps the most troubling outlier event "risk" today for the stock market and economy (we have been contemplating over the last several years) is the possibility of a Chinese invasion of Taiwan . China's leadership has repeatedly stated they are willing to physically take back the island just 100 miles off the mainland. After decades of overtures to reincorporate Tawain's self-ruling government peacefully, China's patience appears to be running thin.

Another credible immediate financial result of any decision by China to invade Taiwan, not getting as much press, is China would likely go head-first into gold assets to protect its currency from western sanctions, at the same moment as investors around the world rush to gold hedges.

Which brings us to the last couple of weeks of gold trading. I have been trying to figure out the reason behind August-September's biggest spike in gold lease rates since late 2008's global financial crisis and Great Recession in the U.S. One reason may be China is ramping up its gold buying in recent weeks, whatever its motivation. In the end, if China decides to attack Taiwan and reclaim this island-state under sovereign Communist control, I fully expect gold to rise far faster than most anyone thinks possible today. Let me explain why.

China/Taiwan History

The history of Taiwan/China friction is somewhat complicated. In 1949, after losing control of mainland China in the Chinese Civil War vs. forces led by Communist Chairman Mao Zedong under the Peoples Republic of China ((PRC)), the Republic of China (ROC) government withdrew to Taiwan under Chiang Kai-shek . Taiwan was ruled (along with some minor islands) as a single-party state for 40 years until democratic reforms in the 1980s. The first-ever direct presidential election was held in 1996. Taiwan experienced rapid industrialization and economic growth known as the Taiwan Miracle , and was recognized as one of the Four Asian Tigers , because of its rapid economic success.

America has supported Taiwan’s government with economic and military aid since its transition to the island after World War II. Yet, since the 1970s, the U.S. has recognized Communist China’s right to claim the island under an ambiguous one-nation policy (based on "One China" ideas formulated under President Nixon ), while still hinting any invasion would likely be defended by American resources and military might. For sure, the whole situation is confusing to understand, as American positioning is not entirely clear, and Taiwan to a degree is a breakaway province created after a civil war.

We have all read for several years about China's expansion in military drills and belligerence against Taiwan, as America has decided to up the ante in public statements of support for Taiwanese independence (despite warnings from Beijing), including plans to send defensive weapons.

There have been numerous stories on U.S. military war games and studies of what would take place in the event of a naval blockade or large-scale invasion of Chinese feet on the ground, with roll playing in 2025 or later part of the equation. The outcome would be extremely costly for both China and Taiwan/U.S. forces. And, final tallies of gaming efforts tip either way for who would control the island.

Physical Gold Shortages Developing

Well, it was reported last week that China's gold buying has still remained in the stratosphere this summer. In August the nation bought 29 tonnes of physical gold metal (its highest monthly total of the year), with 155 tonnes purchased during 2023. For context, 3,100 tonnes were mined globally during 2022. So, the August rate multiplied by 12 months represents around 12% of the world's mined supply annualized. Curious minds cannot help but question the size and timing of buys.

And, the last 18 months have witnessed the greatest net gold bullion purchases by central banks worldwide as a group, since accurate records have been kept from 1950. BRICS nations (including Brazil, Russia, India, China, and South Africa) have been advocating for their economies to de-dollarize for international transactions, while many are pushing to create a new group currency (something like the Euro) backed by gold. In this vein, gold buying volumes by central banks have taken off, pushing prices higher even in the face of credit tightening around the world to fight pandemic inflation.

In recent days, we may have reached the point in gold trading where central banks have found all of the easy to digest supply available in the marketplace. Why do I say that? Over the last several weeks, the physical gold lease rate picture (implied from futures pricing) has bumped to its highest level since the Lehman Brothers failure in late 2008 (green arrows on below chart).

China's Wealth-of-Nations Gold Moment?

I have explained for many years, China owns enough in paper "foreign currency" reserves to effectively corner the gold market at a date and time of its choosing. Chinese ownership of foreign exchange assets (mostly through sovereign bonds) is 15x larger than the U.S. equivalent of foreign paper currency holdings (4x total reserves including gold assets), and roughly 3x the level of nearest cash hoarder Japan.

Now some context. The value of all gold ever mined at today's US$1930 an ounce quote is estimated around $10 trillion (at 32,150 troy ounces per tonne, about 5 billion ounces have been extracted from the earth over human history). But, in terms of readily available above-ground stocks (not in jewelry, electronics, teeth, art, etc.), accessible gold supply is likely less than half this number.

Currently, 45% to 50% of gold mined is turned into gold coins, bullion bars, and ETF holdings each year. So, we can extrapolate the total available gold above-ground stock setup is likely in the $5 to $6 trillion range (assuming higher prices would encourage some jewelry to be sold and recycled) at $1930 gold. Of course, if central banks refuse to sell on higher prices, an estimated $3 to $4 trillion may be all of the "float" of gold that exists today. Central banks collectively own about $2 trillion in gold at present quotes, about 20% of all gold ever mined.

Logically, if China decides to buy gold at even faster rates than the first half of 2023, its $3+ trillion in foreign currency reserves could do wonders for the gold price.

The interesting news is China's official gold position remains far away from U.S. gold holdings of 262 million ounces at $1930 per ounce, working out to $506 billion in value. (Note: U.S. gold reserves held at places like the NY Federal Reserve and Fort Knox, Kentucky are still valued at $44.22 per ounce in government accounting, around the price when we left a gold standard for dollars in the early 1970s.) U.S. gold holdings still represent the largest of any government, standing at roughly 5% of all gold ever mined in human history.

So, if China (holding one-quarter the amount of gold as the U.S.) wants to do a better job of insulating and supporting its currency during an invasion of Taiwan, it may decide to buy materially more gold and quickly (it currently holds about US$130 billion in gold value).

Just like Russia has been a huge buyer of gold before and after the beginning of its invasion of Ukraine, an effort to thwart the effect of trade sanctions from western nations on the ruble, China may be forced to purchase gold at 10x to 20x the rate of 2023 purchase volumes to support the yuan. That's the clip it would take for China to get to an "equal" gold position with the U.S., depending on 12-month or 24-month buying timelines. (This assumes President Xi would want to pull China's gold holdings closer to par with U.S. positioning.)

Believe it or not, China can easily "afford" to buy this amount of gold, simply from selling its paper currency reserves valued at over US$3+ trillion. $3.25 trillion in paper currency reserves have previously been used as leverage over trading partners like the U.S. But, if China circles the wagons during an attack on Taiwan, I fully expect western currency reserves will be exchanged for as much gold as China can find, even at prices $1000 to $2000 an ounce above $1930.

I will say my average relative pricing "fair value" for gold, based on M2 and Treasury debt growth over decades, the ever-rising industry cost of mining/production, plus changing commodity and equity price levels, is close to $3000 an ounce right now. My foundational bullish argument is current market pricing under $2000 already represents something of a bargain historically. You can read some of my past gold stories over the years explaining how I come up with this number.

A back of the envelope guestimate for price sensitivity to possible China buying in the future is every $1 trillion switched from fiat currencies to gold (which represents a whopping 10% of gold value ever mined in today's pricing) could increase this leading monetary metal's quote by around $1,000 per ounce. I am modeling a rapid $1 trillion exchange would also put Chinese gold holdings above the total U.S. position. $2 trillion would bring gold prices closer to $4000 an ounce, which would be slightly overvalued in my relative data figures, all other variables remaining the same.

$3 trillion in buying power would bring gold closer to $5000 an ounce, while basically exhausting all of China's paper currency reserves. Of course, $5000 would be "overvalued" in my work, but still dramatically below the early 1980 all-time high of $9,000 an ounce converted to today's adjusted dollar worth (using my formula, measured from its $800 actual price high). This "full" exchange effort would also allow China to achieve the greatest gold weighting of any nation since America won World War II, with 15%-20% of all gold ever mined potentially controlled by China!

Remember the "golden rule" throughout human history: He who owns the gold, makes the rules.

Final Thoughts

If China did retake Taiwan while materially jumping its gold ownership, such might usher in a long-anticipated conversion of the nation's economy from an export-centered manufacturing machine to a richer and more stable consumer-led economy. For example, if the Yuan's value actually rises (with its newfound strong gold backing) vs. foreign currencies like the dollar, the relative size and wealth of China's consumer spending in international markets would rise materially.

And, China's takeover of nearly the entire high-tech computer and electronics supply chain (both in China and Taiwan) would be another critical consequence of any successful attack on this democratically-structured island to consider.

I estimate the U.S. stock market would fall between -20% to -30% on a Chinese decision to invade Taiwan, at least initially (considering our overvalued position historically using Total Market Cap to GDP or the Shiller P/E Ratio). And, if China wanted to inflict a toll/trade tariff on U.S.-sold goods made in China and Taiwan, our economy could be stuck in a negative growth loop for a number of years.

Warren Buffett's Berkshire Hathaway ( BRK.A ) ( BRK.B ) liquidated its Taiwan Semiconductor Manufacturing ( TSM ) shares in late 2022 after rethinking the China invasion risk to operations . Can you imagine the negative impact on semiconductor stocks like NVIDIA ( NVDA ) and Advanced Micro Devices ( AMD ) that outsource most of their chip production from Taiwan?

Just last week, the Chinese government mandated workers stop using Apple ( AAPL ) iPhones . Hurting a big demand market for the company, Apple shares slid -8% in kind. On top of this issue, Apple's whole supply chain for computers and gadgets is centered on cheap Chinese/Taiwanese production, with the help of contractor Foxconn . So, this U.S. business is particularly susceptible to a China vs. Taiwan military war.

What are the realistic chances of trouble? That's a great question. The purpose of this article is to highlight what China could do in the gold market, while giving readers a chance to research and weigh the facts on their own. If you have a different view on what would happen during an invasion, please express them in the article's comment section below.

It appears most Wall Street analysts and mainstream investors are so fixated on Federal Reserve tightening, other reasons to hold gold are not seriously contemplated right now. The largest geopolitical risk for U.S. equity investors since World War II may be staring everyone directly in the face today. My contrarian take on the situation is to prepare and invest for a dramatic jump in gold quotes, especially if a recession allows the Fed to pivot to easing bank credit conditions into 2024.

I have become very bullish on gold bullion and related miners over the last month. China's potential buying interest, at a totally different degree than 2023, could create a dramatic surge in gold between now and 2025. Regardless of Federal Reserve policy, and outside the control of western leaders and bankers, China has the wherewithal and perhaps the motivation to spike gold prices if the decision to attack Taiwan is made.

I rate gold bullion ETFs like SPDR Gold Shares ( GLD ), iShares Gold Trust ( IAU ), abrdn Physical Gold Shares ( SGOL ), Sprott Physical Gold ( PHYS ), VanEck Merk Gold Trust ( OUNZ ), GraniteShares Gold ( BAR ), and Goldman Sachs Physical Gold ( AAAU ) as good places to start in your brokerage account.

Other leveraged gold hedge ideas, which I have been discussing in SA articles this year, include ProShares Ultra Gold ( UGL ), plus related mining ETFs like VanEck Gold Miners ( GDX ), VanEck Junior Gold Miners ( GDXJ ), and Direxion Daily Gold Miners Index Bull 2x Shares ( NUGT ). I have also mentioned about 10 individual mining concerns over the last 12 months. You can scroll through my list of articles and find them if you like.

Absolutely, if China wanted to, it could theoretically send prices $1000 to $2000 an ounce higher (at its discretion), especially if leaders think through the likelihood of international economic sanctions after an attack on Taiwan. China's heavy gold buying in 2023 may or may not be related to planning for an invasion in 2024-25.

An attack on Taiwan would be an outlier black swan event super-bullish for gold prices, while a once-in-lifetime negative for the global economy, especially many technology stocks. Food for thought anyway. At the very least, owning a few gold assets as a hedge against real geopolitical trouble in the global economy (with similar effects to the COVID-19 pandemic of 2020-21) is a reasonable proposition during early September.

I personally would prefer some sort of negotiated settlement in the dispute, perhaps with a 20-year or 30-year date for reunification of Taiwan's government with the mainland. Such would give people on the island time to immigrate to other areas of the world and businesses the ability to relocate operations in an orderly manner, if they choose that path. Maybe an extra degree of election autonomy, beyond what Hong Kong has been able to achieve, would be an agreeable compromise to prevent the large loss of life and complete disruption to the global economy in a military conflict.

I do hope I am wrong about the rising odds of China invading Taiwan over the next 12-24 months. It would not be fun or profitable for anyone, with potentially hundreds of thousands of lives lost like the Russia/Ukraine conflict. However, putting your head in the sand and saying such will never happen could prove a horrible option for your portfolio.

Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.

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