SINGAPORE (BLOOMBERG) - From an accelerated decoupling of the world's two largest economies to a discussion on whether China might weaponise its vast holding of US Treasuries, strategists are outlining how US House Speaker Nancy Pelosi's Taiwan trip may ripple across global markets.

Mrs Pelosi’s visit has fanned fresh jitters among investors already spooked by the threat of a global slowdown amid surging inflation. Some strategists warned of dismissing China’s initial response too early - military exercises and some Taiwan trade restrictions - with markets vulnerable to any hint of a worsening of China-US relations. 

“This issue will linger far longer than the market’s attention span will allow,” said Michael Every, head of Asian financial market research at Rabobank. “Yet geostrategists are largely united in the view that we are still worryingly close to a potential Fourth Taiwan Strait Crisis.”

China and Treasuries 

Investors were still parsing headlines and market moves Wednesday for clues as to how China could retaliate. The dizzying surge in Treasury yields overnight triggered discussions whether Beijing might weaponise its near US$1 trillion (S$1.38 trillion) pile of US government bonds. Chinese defense stocks rose while Taiwanese shipping and tourism shares retreated.

“Given the magnitude of the sell-off, it was only a matter of time before speculation that China was using its significant Treasury holdings in retaliation for Pelosi’s visit,” said Ian Lyngen, a strategist at BMO Capital Markets. “In the event this is the case (which we doubt), the bearishness should be limited as the near-term flow influences are overshadowed by the negative impact on the global macro outlook.”

Others such as Huang Huiming, a fund manager at Nanjing Jing Heng Investment Management, are bracing for the start of “salami tactics” by Beijing - a piecemeal approach to divide and conquer an opposition - and how this could impact already choked up supply chains. 

“Looking closely at the exercise zones, this is the nearest to the island ever and encircles it - all military operations are at first disguised as drills,” said Mr Huang. “We might be concerned if the drills become longer and more intense to impact supply chains, but there is no sign of that happening now.”

Faster decoupling

While some investors are looking to sell the rumour, buy the news for now onMrs Pelosi’s visit, others are mapping out a longer-run macro view of how this could prove to be a seminal moment in Asia-Pacific history and potentially alter asset-allocation in the region. Taiwan is a critical global supplier of semiconductors and other high-tech goods. 

There are risks of a longer-term economic decoupling between the world’s two largest economies with a slew of potential impacts including fresh stress on supply chains worsening inflation. Beijing has already announced the beginnings of an economic response, halting natural sand exports to Taiwan and stopping imports of fruit and fish. 

“The official return of the US influence in Asia-Pacific will inevitably accelerate US-China decoupling,” said Bao Xiadong, a fund manager at Edmond de Rothschild Asset Management in Paris. “Given it’s an evolving event, investors should brace for a test of nerves which may implicate high market volatility in the near-term.”

Caution prevails

“Right now we think the tone has been set for equities for August and the rest of the year. Geopolitical tensions will rise,” said Jessica Amir at Saxo Capital Markets. “We also see the return to safe havens, and the dollar to see increased buying.”

It’s an outlook shared by AMP Capital Markets’ chief economist Shane Oliver, who sees gains for Treasuries to gold should the visit spark actual conflict. “Longer-term it signals a further escalation in cold war tensions between the West and China/Russia which means higher risk premiums,” he said.

Sentiment to recover

In Zurich, fund manager Jian Shi Cortesi sees parallels in market outcomes between Newt Gingrich’s trip to Taiwan in 1997 and Mrs Pelosi’s today. Back then, the Hang Seng Index and Taiwan’s bourse both fell before the visits, but rebounded strongly afterwards. This time around, investors saw similar weakness for China, Hong Kong and Taiwan stocks prior to Mrs Pelosi’s trip.

China’s military exercises near Taiwan island “may still keep investors on their toes,” said the investment director at GAM Investment Management. “Market sentiment will recover once the military exercise ends.”