The Next Chapter for the Hottest "Hot Spot" on the PlanetBy William Patalon III, Executive Editor, Money Morning • May 14, 2016 View Comments Start the conversationLeave a Reply Click here to cancel reply.Your email address will not be published. Required fields are marked *Name * Email * Website 5 + one = Comment Some HTML is OK Sign me up for the Money Morning newsletter William Patalon IIIOn Monday and Tuesday, we brought you a detailed report about the "hypersonic arms race" – and the potential for a "snowball effect" threat to global security.And we warned you – yet again – that the destabilizing "snowball" would start its roll because of the escalating dispute in the South China Sea.On Tuesday, we all got another real-world reminder of how risky that dispute actually is.The U.S.S. William Lawrence was conducting what the U.S. Navy refers to as a Freedom of Navigation Operation (FONOP) within 12 nautical miles of the Fiery Cross Reef. In response, China scrambled two fighter jets and an early-warning aircraft and sortied two ships.The Fiery Cross is one of the artificial reefs Beijing has built in the South China Sea. China refers to this island construction as "land reclamation." Before this "construction" or "reclamation, Fiery Cross used to be submerged at high tide – except for two rocks.China's military got especially hot about this Navy maneuver because Fiery Cross is home to a hefty military presence, including a 10,000-foot runway that's long enough to host just about any kind of military aircraft in the world.For the Navy, this was the third "FONOP" operation since the exercises began last year.Hot Spot, Hot StoryIn the four years we've been following this, we've repeatedly offered one warning: Any time there's a dispute like this, it only takes one miscommunication, one mistake, one overtly aggressive act (and "aggression," like beauty, is often in the eyes of the beholder) to ignite real shooting.And as cliché as it sounds, emotions are running high in that part of the world.China, Japan, Taiwan, Vietnam, Brunei, Malaysia and the Philippines all claim one section or another of the various islands and waters in the region – and most of those claims conflict. It's a region that's home to 1.5 billion people – as well as rich fishing grounds, vast energy deposits, key military bases, 50% of the world's tanker shipments and five of the Top 10 shipping ports on Earth. (To see the actual claims, check out this accompanying map.)The United States and these other nations claim that these should be navigable waters, and that the resources should be shared by all claimants. Indeed, several of these countries – including the Philippines and Vietnam – have asked for "multilateral" talks that would include all the interested nations.But China wants "bilateral" talks – where it would "negotiate" with each country on a one-on-one basis, while leaving the United States foreign-policy apparatus on the curb.The United States is shifting its East Asia policies because of this situation, and countries like Japan are altering their military policies in a big way.Put it together and you have the ingredients for a major "event" that could get pretty ugly pretty quickly.We got a glimpse of that this week, following the Navy maneuvers. The "snowball effect" was observable – although this one more-rhetoric-based.Beijing quickly blasted the U.S. move and promised a strong response. The People's Liberation Army's Col. Yang Yujun called the "unauthorized illegal entry into Chinese waters near China's Nansha (Spratly) island by the U.S. warships and warplanes… a serious provocation." On Wednesday, China's Ministry of National Defense announced an escalation in patrols by military ships and airplanes – and promised the construction of "various defense capabilities" in the South China Sea.As always, others weighed in, too.Although the Pentagon says this naval maneuver serves to challenge claims by China, Vietnam, Taiwan and others that "require prior permission or notification of transits through the territorial sea" by military vessels "exercis[ing] the right of innocent passage."(According to the legal blog Lawfare, "innocent passage" usually refers to the right of ships to pass through a territorial sea built around a rock or island – so long as that vessel doesn't perform military maneuvers or get involved in any intelligence gathering.)Lawfare's Julian Ku argued that the United States should seriously consider "non-innocent-passage" operations that would "directly challenge … the legitimacy of China's artificial islands."Everybody's TalkingPerhaps realizing how quickly things were escalating, top generals from the United States and China reportedly talked by phone on Thursday and said they would try to work out an "effective mechanism" to maintain peace and avoid additional confrontations in the region.In a video conference with Chairman of the U.S. Joint Chiefs of Staff Joseph Dunford, China Chief of the General Staff Fang Fenghui said that China values freedom of navigation "more than any other country in the world." And while denying Beijing was the source of the current tensions, Gen. Fang said his country wanted to see better communication and cooperation with Washington, according to a report from ABC News."The common ground and prospects for cooperation between China and the U.S. far exceed our disagreements and contradictions," Gen. Fang said, noting that his country wanted to use the "big picture" of Chinese-U.S. relations as the basis for approaching the South China Sea issue.But as we noted in our two-part report this week, the militaries of the two countries are also taking the "long view" – and are developing weapons systems that are aimed at gaining the military upper hand.For investors, this is a story that's critical to follow. Any clashes – especially those that promise to escalate the spat – will have a big, big impact on the worldwide capital markets. And in defense-contracting circles, there will be very definite winners from these initiatives.We'll keep an eye on this one for you…Have a nice weekend.