Market's next concern may float in South China Sea

Although recent price action suggests otherwise, a slow-burning geopolitical situation in the South China Sea may yet become a flashpoint for market volatility.

The U.S. is talking tough in the face of mounting evidence of Chinese land grabs and military movements near its neighbors, and Beijing is defiant. The threat of a confrontation between the world's two largest economies hasn't registered on traders' radars, that may change, some say.

"Market mentality has a tendency toward complacency, and right now, geopolitical risk is nowhere on the radar screen. That could be a major mistake," Chicago-based trader Jim Iuorio warned.

"The developments in China seem to be moving in one direction, and although they may not seem to be a problem now, that could change quickly," he added.

The topic also found its way into the somewhat rambling remarks last week of former Lehman Brothers CEO Dick Fuld.

Read MoreLehman's Fuld: No one thing caused the crisis

The disgraced executive, whose firm's collapse hastened the 2008 financial crisis, folded the conflict into a laundry list of geopolitical worries for stocks. These included Russia's military encroachments, and the threat of a nuclear Iran.

War 'inevitable'?

Chinese dredging vessels are purportedly seen in the waters around Mischief Reef in the disputed Spratly Islands in the South China Sea in this still image from video taken by a P-8A Poseidon surveillance aircraft provided by the United States Navy May 21, 2015.
U.S. Navy/Handout via Reuters
Chinese dredging vessels are purportedly seen in the waters around Mischief Reef in the disputed Spratly Islands in the South China Sea in this still image from video taken by a P-8A Poseidon surveillance aircraft provided by the United States Navy May 21, 2015.

While the South China Sea issue is not new, at the very least, it is beginning to produce some increasingly scary headlines.

A newspaper which often serves as a mouthpiece for the Chinese government threatened last week that war with the U.S. is "unavoidable" unless Washington backs down from its current position.

The specter of war is unlikely to materialize, yet experts are cautioning that tensions could flare up into some form of military engagement.

"Everyone involved realizes that any kind of serious armed conflict over these islands would be a huge disaster, and in no one's interest," said Mira Rapp Hooper, director of the Asia Maritime Transparency Initiative at the Center for Strategic and International Studies. "But we should be concerned by the risk of inadvertent or accidental escalation."

Read MoreUS defense chief: China island-building erodes security

The islands in question—which are also claimed in part by several countries including Philippines and Vietnam—have seen explosive Chinese land reclamation and infrastructure building in recent years.

The U.S. and its Asian allies have expressed worries that those developments may represent offensive military posturing by Beijing, and that the Chinese may ultimately seek to restrict or even bar free naval passage in the area.

Some countries have also accused China of seeking to exploit the energy resources in the disputed areas. Protests sprung up in Vietnam last May, in response to a Chinese oil rig in what they perceived as their waters.

'Aggressive' interference, China tells US

This round of tensions were incited by public revelations the Chinese had been building at a breakneck pace, and that they'd placed military equipment in the area.

Even while admitting that the islands could serve a military purpose, China maintains those actions are well within its territorial rights, and insists the U.S. "is taking a dangerous gamble" with "aggressive" interference.

"We do not want a military conflict with the United States, but if the conflict must come, we should accept it," an editorial in a Beijing-run newspaper says.

Read MoreAsia defense spending: New arms race in South China Sea

Despite Beijing's charges of an insecure power attempting to humiliate it, the U.S. actions have been appropriate, according to CSIS's Hooper.

"The U.S. response is representative of the fact that a lot of developments have occurred very quickly and are raising grave concerns among other claimants in the region," she said.

But tensions are much higher than normal now—Hooper called it "a bit of a crisis feel"—and a misunderstanding between China and a Vietnamese vessel, for example, could readily provoke an international incident, she explained.

Read MoreChinese naval push could affect global trade

Despite all the bluster on both sides, the real threat to stability may be continued lack of understanding.

"We don't really understand what China's doing with these islands, we don't understand what they think their rights are when it comes to these islands, and that could potentially lead to a dangerous clash," Hooper said.

'Who cares?'

If the situation continues to escalate, the first assets likely to be affected are Asian currencies and Asia-exposed currencies.

"Even though it's been a story we've been hearing about for months, the situation has exacerbated, and the anxiety and uncertainty in the region will hurt the Chinese yuan and the Japanese yen, and possibly the Australian dollar," predicted currency trader Kathy Lien of BK Asset Management.

Even if military engagement can be avoided, "you may still see sanctions, and sanctions would not be helpful for the Asian currencies," she explained.

In American markets, further tensions would support a classic "risk-off" move, theoretically hurting stocks, but more directly spurring demand for safe-haven assets such as the U.S. dollar.

"Any kind of tensions there would be dollar-positive and U.S. Treasury-positive," said Win Thin, global head of emerging markets strategy with Brown Brothers Harriman.

That said, the issue has clearly not yet become a catalyst for the stock-market. In fact, some traders have been outright dismissive of the whole affair.

"Who cares," Rhino Trading Partners chief strategist Michael Block told CNBC in a curt replied response to an e-mail inquiry.

Indeed, a messy or belligerent outcome is not yet the base case. Jeff Kilburg of KKM Financial told CNBC's "Futures Now" last week that "the situation needs to escalate a lot more for the market to really get concerned about it."

But if China and the US shift from rattling their sabers to unsheathing them, markets are much more likely to pay attention.

—By CNBC's Everett Rosenfeld and Alex Rosenberg.

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