Chance of North Korea crisis escalation has investors’ attention

Global equity markets shuddered last week when the rhetoric between North Korea and the Trump administration heated up following the unanimous adoption of tougher U.N. sanctions against North Korea’s nuclear weapons program. The exchange of threats culminated in the president’s “fire and fury” speech, which prompted the Dow Jones Index to fall by 0.15 percent, just a few days after the index celebrated its first ever close above 22,000.

Will this be more than just one of the many short-term setbacks we have seen in the current equity rally or does this geopolitical risk event have the ability to affect the broader market trend?

{mosads}When we look at geopolitical risks and the likely impact on financial markets, including potential portfolio performance, we have to ask two questions: First, are the any direct or indirect links between the geopolitical risk event and the broader global macroeconomic backdrop underpinning financial markets right now? Second, what are the chances that the geopolitical risk event mutates from its current form or intensifies in its current nature?

Finally, we apply a market valuation filter, which helps us understand the magnitude of a possible market reaction if market valuations are already stretched, the downside is likely to be larger than the subsequent rebound potential. That is indeed the case right now, which is why we need to pay extra attention to all types of geopolitical risk events.

Every such event is different. The risk of military confrontation itself doesn’t necessarily move markets. Take the Syrian civil war. It lacks a transmission channel to influence market expectations for global growth or global monetary policy, or other factors underpinning broader market trends. Syria is not a major growth contributor, and the conflict doesn’t impact commodity prices or threaten trade flows.

At first glance, it may seem like a similar situation with North Korea. The country itself is largely outside the global economic system and poses no immediate threat to the free flow of trade in the region. However, the greater risk is the conflict spreading to involve North Korea’s neighbors — South Korea, China and Russia.  

Where North Korea differs more directly from Syria is in its intensification risk. Despite the fact that many outside actors are involved in the Syrian civil war and the fact that Syria has used chemical weapons, the conflict has not intensified or expanded beyond the immediate region. This looks different in the case of North Korea.

The availability of highly destructive weapons and the proximity of large population centers in South Korea raise the probability that a series of actions and counteractions could escalate the crisis rapidly through perceived red lines. As long as the escalation level remains low, markets will largely treat North Korea as a tail risk event and focus instead on possible changes to U.S. monetary policy or the risk of a slowdown in China. 

In fact, in looking at the list of possible tail risks, another U.S. government shutdown seems a more likely risk event than an escalation beyond a “war of words” with North Korea. According to the Treasury Department, the U.S. government will run out of money by the end of September. Congress is on summer recess and will only have 12 working days in September to address the issue.

The failure to pass healthcare reform highlighted serious differences among congressional Republicans that threaten to undermine any agreement on the debt ceiling. It would not be surprising if nobody is talking about North Korea a month from now, yet another U.S. debt ceiling crisis is roiling global stock markets.       

The increase in geopolitical event risk in the Korean Peninsula warrants monitoring, especially against a backdrop of elevated market valuations that increase the downside skew in a market reaction. Yet, this particular risk event has not reached a level that would prompt changes to our market outlook.

North Korea has very few direct links to the broader global macroeconomic system. Hence, there is far less feedback risk from increased sanctions on North Korea than from sanctions against Russia, which not only slow growth in a key emerging market economy, but also impact growth in Russia’s Western European trading partners.

However, intensification risk with North Korea is high, and an escalation to even limited military action could reach a level that would draw other countries into the conflict. That could quickly affect the economic expectations underpinning global equity and bond markets. North Korea is only one of a number of possible global risks investors need to monitor right now. It’s a classic low probability/high impact event that has the potential, albeit low, to be this year’s “Black Swan.”

Markus Schomer, CFA, is the chief economist at PineBridge Investments, a private, global asset manager.

The views expressed by contributors are their own and not the views of The Hill.