Geopolitical Tensions Increase as North Korea Threatens to Strike Guam

By: David Stonehouse, Mark Weinberg • August 11, 2017 •

North Korea Becomes a Top Global Risk

North Korea has increasingly become a major global risk with rhetoric ratcheting higher in August. In July, the country launched two missiles. Recently, news outlets reported that the U.S. Defense Intelligence Agency believes North Korea has already developed a miniature nuclear warhead that could strike the U.S. military base in the Pacific island of Guam. President Trump responded harshly, stating that North Korea would “be met with fire, fury and frankly power the likes of which this world has never seen before” if the threat continues. He subsequently stated that “military solutions are now fully in place, locked and loaded, should North Korea act unwisely.” Also, Japan upgraded its assessment of North Korea, stating that this new threat has now entered a “new stage.”

 

Chance of a Military Confrontation and Impact on Regional Allies

The possibility of a military confrontation has clearly escalated to the highest level in several years, although a major conflict is still fairly unlikely as a war of words seems more probable. Intercontinental ballistic missiles (ICBMs) launched in recent weeks led the United Nations to pass new sanctions last weekend, a diplomatic success for the United States. However, even China’s agreement to sanctions against North Korea could be at risk if Trump continues his belligerent remarks. Russia could also get involved in the situation, although it may seek to undermine the U.S.’s influence within the region. The best outcome is a unified diplomatic effort involving some combination of China, the United States and Russia. Still, regional American allies South Korea and Japan have had to consider diplomatic and military contingencies. These geopolitical tensions could potentially weaken the long-standing relationship that the U.S. has enjoyed with both countries.

Recent rhetoric from North Korea suggest they are focused more on U.S. targets than Japan and South Korea. While these two countries have been living under the threat of North Korean strikes for years, what has changed is the increasing potential for North Korea to threaten the continental United States. In the near term, focus will remain on government and public responses and sentiment in Asia to President’s Trump’s “fire and fury” promises and any further potentially threatening comments. Any major American military action against North Korea, particularly unilateral, would invoke widespread condemnation in the region, not just from major rivals like China and Russia but also from allies like Japan and South Korea.

 

North Korea’s Clout Has Increased

Now that North Korea appears to have the technology to reach the continental United States (including reports that it now has nuclear warheads), it is highly unlikely that it would abandon such programs on its own accord as these new capabilities help ensure the survival of the regime.

These advancements have also dramatically increased its bargaining leverage with its adversaries. While sanctions hurt the North Korean economy, they have not materially altered its focus on advancing its missile and nuclear program. Another question to ponder is how this may change the military programs of other nations in the region, such as Japan. It also begs the question of how other rogue nations, such as Iran, view these developments in terms of their own ambitions.

 

Market Impact

Market reaction to the escalating tensions had been muted until this week, as markets declined sharply on Thursday due in part to North Korea’s threat to target Guam and Trump’s subsequent harsh response. This resulted in a repricing of South Korean risk assets and global safe havens, benefiting the Japanese yen, Treasuries and gold. If the situation involves a high degree of rhetoric and diplomacy investors are more likely to remain complacent, and the market impact should be minimal. Of course, if the threat of armed conflict becomes more apparent, risk assets should endure a larger repricing, while the traditional safe-haven assets will benefit.

Still, from a historical standpoint, geopolitical events tend not to be big market movers following a knee-jerk market reaction. There have been few instances where the market has remained negative for long following a significant event, which has frequently created good buying opportunities for investors. 

In the majority of cases, markets have been higher, three, six and 12 months following a geopolitical event, as the economic impact has not been significant and earnings have not been impaired. The exceptions have been either prolonged major wars such as World War II (and even then, examples such as Pearl Harbor and the Korean War did not result in large declines since the market had already moved down so much and was so inexpensive), or periods when valuations were high and bear markets ensued, often accompanied by recession.

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Published Date: August 11, 2017