After removing old wainscoting we discovered a second layer of wood paneling that is between 22'' and 36'' high (depending on location) and slightly set back from the drywall above. The drywall protrudes about 1/8''. The second layer of wood paneling is lead-painted. See picture below.
One option would be to tear everything out and install sheetrock but it's a mess with the lead-paint etc.
So here is my question: What material in 1/8'' thickness can I use to cover the wood paneling and have an almost seamless transition between the drywall and the bottom of the wall after mudding and painting. The goal is that everything just looks like a normal sheetrock or plaster wall. Sheetrock is only available in 1/4'' so it's not an option. Would 1/8'' hardboard work? 1/8'' plywood? Any alternatives?