Markets & Economy

Asia ex Japan

North Korea’s Risk Escalation—Where to From Here?

August 31, 2017
North Korea’s risk escalation and the impact on markets.

Key Points

  • North Korea has recently carried out two successful intercontinental ballistic missile tests—the second one, in particular, demonstrating the potential capability to strike West Coast U.S. targets.
  • In response to strong rhetoric from U.S. President Trump, North Korea proceeded to launch a missile over Japan’s northern Hokkaido island, marking a new level of risk escalation.
  • In recent weeks, the reaction in major markets to the escalating tensions has been reasonably measured. However, the missile launch over Japan has caused global equity markets to pull back in early trading. Safe havens like gold have rallied, and the euro and yen have risen versus the U.S. dollar.
  • While military options are on the table, any immediate risk of conflict remains low, in our view. Ultimately, we see a resumption of the uneasy stalemate between the two nations as the most likely outcome.

The standoff over North Korea’s nuclear capability is escalating, adding another geopolitical event to a market landscape that, so far, has taken such events in stride. In recent weeks, market sentiment appears to have been little affected by the escalating tensions between North Korea and the U.S., seemingly dismissive of a potential military outcome. However, the latest missile launch over Japan represents a clear escalation in tensions, and it remains too early to tell what impact this might have on market sentiment. Yet any immediate risk of conflict remains low in our view, given that the recognized costs of such action are exceptionally high.

Nevertheless, this summer has been witness to a number of significant developments. Since early July, North Korea has carried out two successful intercontinental ballistic missile tests—the second one, in particular, demonstrating a significant extension of range, giving it the potential capability to strike West Coast U.S. targets.

U.S. President Donald Trump responded to North Korea’s threats with some of his own, vowing to “unleash fire and fury like the world has never seen” on North Korea. The U.S. ambassador to the UN, Nikki Haley, also spoke in no uncertain terms, saying that “the time for talk is over.”

The tough line from the U.S. only prompted North Korea leader Kim Jong-un to raise the stakes further, by initiating a plan to test missiles close to the Pacific island of Guam. North Korea ultimately backed down from this direct threat toward a U.S. territory, only to subsequently launch a missile test over northern Japan. This latest escalation of events raises the stakes and crystalizes some of the risks.

…the latest missile launch over Japan represents a clear escalation in tensions, and it remains too early to tell what impact this might have on market sentiment.

ASSESSING THE POTENTIAL SCENARIOS

North Korea has cultivated a reputation as a volatile and unpredictable player on the world’s stage. The direct threat to launch test missiles so close to Guam, and then carrying out a surprise launch over Japan’s Hokkaido island, is a departure from typical North Korean threats and a high-risk move. North Korea’s unpredictability substantially increases the risk of escalation.

Still, much remains uncertain. Markets tend to not react well to uncertainty, but at T. Rowe Price, we are staying informed and are able to be responsive to a number of scenarios, which we have outlined below.

Along the potential outcomes spectrum, there are a number of scenarios that could play out from here, ranging from an easing of tensions and a continuation of the stalemate between the two countries right through to all-out military conflict, with the U.S. provoked into launching a targeted strike on North Korea, whose regime could respond with full-scale military retaliation. While the risk of this worse-case scenario playing out is still low in our view, pressure remains high, as does the risk of a mistake of judgment.

IMMEDIATE MARKET IMPACT

As far as financial markets are concerned, the response to the escalating tensions has, so far, been relatively watchful. Major equity markets have held up reasonably well in recent weeks, easing only marginally in response to the escalation in tensions. That said, in the immediate aftermath of the latest missile launch over Japan, volatility has noticeably risen, with global markets experiencing some selling pressure in early trading. Meanwhile, safe-haven assets continue to be well bid, with gold hitting 12-month highs, while the euro and yen have both risen sharply versus the U.S. dollar.

That said, given the increase in risk, the appeal of both South Korean credits and equities is certainly impacted, with several T. Rowe Price managers reducing the risk profiles of their funds, including the Emerging Markets Bond Fund and Total Return Fund. Most T. Rowe international fixed income portfolios have hedges on the South Korean won given how little risk premium is priced in.

In the collateralized debt securities space, South Korea has notably underperformed Hong Kong and, while it has converged with China/Thailand, this is mainly due to compression in both of these markets. Portfolio managers appear to be using the disconnect between U.S. market reactions and those in South Korea, Taiwan, and Japan to adjust their portfolios. Adjusting to such market developments represents a strength of T. Rowe Price’s active management approach. Most managers are hedging their foreign exchange exposure, either directly or using out-of-the-money puts. Meanwhile, equity portfolio managers are generally taking a more cautious stance toward South Korean equities. The KOSPI Index has felt the impact of the uncertain environment, down around 2.5% during August after having started the month at an all-time high level. However, it is worth noting that, despite its recent strong run, South Korea is already the cheapest major stock market in the world, while the U.S. is the most expensive.1

MILITARY ESCALATION—IMPLICATIONS FOR MARKETS

Should tensions escalate, and should direct military action on the Korean Peninsula develop, we would likely see a significant impact on world financial markets. The spike in uncertainty would see a similarly sharp rise in volatility as investors de-risk and rush for safe havens. Ultimately, however, we do not envisage a major market collapse. If recent conflicts like the wars in Iraq and Afghanistan are anything to go by, the direct impact on the U.S. economy and markets would likely be reasonably limited. U.S. military action in Asia would not directly affect U.S. companies or corporate earnings nor have any material impact on the economy.

The indirect effects, however, could be far more substantial, given the serious consequences for Asian economies. South Korea and Japan would bear the brunt of the damage in any conflict, and these are major trading and manufacturing hubs. South Korea, for example, is a major supplier of electronics and auto parts globally, and disruption in these countries would break supply chains around the world, possibly for weeks or months. That could lead to a temporary cessation of global trade. At the same time, any military conflict would see market sentiment undermined and may force global central banks to act in order to shore up confidence.

The direct effects, however, would be most serious for South Korea. Most military assessments conclude that North Korea’s military would likely collapse in two to three months, but not before inflicting significant damage and civilian casualties on Seoul. At this point, there is a real risk that the North Korean regime, facing annihilation, may simply detonate its formidable arsenal of weapons of mass destruction (including an estimated 30‒60 nuclear bombs and chemical and biological weapons) on both South Korea and Japan.

READY FOR ANY OUTCOME

Volatility is likely to increase over the coming months, but current geopolitical tensions are not unprecedented. As such, we remain alert to any potential developments and are positioned accordingly. Political uncertainty in the past has often proved an opportune time to take on some risk in a portfolio. Given our active, research-driven investment style, we can often react early to opportunities that volatility presents, and capitalize as the markets catch up and the assets are rerated.

In the past, the U.S. has always been willing to step back and defer the North Korea problem, but with the current threat reaching a level not seen before, the U.S. may feel compelled to respond militarily. However, while tensions remain high, any risk of such action is not immediate in our view. The market’s reaction, so far, has been reasonably measured, and we continue to believe that the most likely outcome is that we settle into a new paradigm, either through negotiations or through a cold war-style deterrence route.

1StarCapital Research, as of July 31, 2017. Based on price-to-earnings and cyclically adjusted price-to-earnings valuation metrics.

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of September 2017 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments involve risk. All charts and tables are shown for illustrative purposes only.

T. Rowe Price Investment Services, Inc., Distributor.

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