It seems like North Korea has overtaken Iran as the biggest geopolitical black swan for 2013. A potential nuclear capacity and a young, bullish leader in the form of Kim Jong-un could prove to be a toxic combination if things do reach a head. But are these threats from Pyongyang idle, or should the investment community treat them seriously?
The trouble with geopolitical issues is that they are notoriously hard to plan for. Traders and investors are usually not privy to information in the lead up to an attack, which means that we hear about them in the papers, usually after they have happened. In these situations you are forced to be reactionary.
As geopolitical tensions heat up it can fuel uncertainty, and since markets hate uncertainty, it can have an impact on asset prices. Added to that, it is hard to use previous examples of geopolitical tensions as a template for how markets could potentially react to an attack by North Korea.
The most recent escalation of nuclear threats prior to North Korea was Iran and Israel. Back then oil was the big asset at risk - a nuclear strike by Iran could have caused the price of oil to soar as investors grew concerned that a retaliatory attack from Israel/ the US could have disrupted oil supplies. But North Korea isn't an oil producer; in fact it doesn't really produce anything because its boarders are so firmly closed. Instead, North Korea is a threat because of the importance of the Asia region to the global economy.
Let's imagine that North Korea fired at South Korea causing much damage. This may spur a retaliatory strike by the South, and potentially the international community. This could affect the wider region, including China and Japan, Vietnam and Thailand. While modern warfare doesn't necessarily disrupt trade flows like it used to, it could definitely weaken risky assets in these regions, weighing on equity and credit markets and thus disrupting growth. Since Asia is such a powerful force in global growth, shock waves could hit markets elsewhere, like US and European stock markets. Added to this, it's not difficult to envisage a nuclear war devastating consumer, economic and investor confidence, not just in the countries' effected but across the globe.
So will North Korean leader Kim Jong-un pull the trigger? There is a good chance that he is just posturing. He is a young leader, at only 32 years old, and he wants to make his mark on the global stage. So far his threats, including telling the UK to remove its embassy staff from South Korea, have been empty. Added to this, there is doubt over whether the North Koreans have the nuclear capacity that they claim.
North Korea has threatened to target Kaesong, which is a trade zone run jointly by the North and the South. However, this trade zone is an important source of foreign currency reserves for the North. Thus if Pyongyang did target this area, it would essentially be shooting itself in the foot, as the area is much more important to the North than it is to its much richer neighbour in the South.
Kim Jong-un also may have an ulterior motive for triggering this escalation in tensions. The North Korean populace are widely believed to live in poverty and near famine; some believe that the recent actions by the young Kim Jong-un is a ploy to orchestrate diplomatic negotiations with the US so the North can try and negotiate more aid in return for keeping the peace.
Even so, precautions against North Korean aggression have been taken. The US has fired up its nuclear interceptors on the West Coast. Also, South Korea has cancelled a nuclear missile test in an attempt to limit an escalation of this crisis. North Korea has said that from April 10th it could launch an attack. April 15th is the anniversary of the founder of present North Korea and Kim Jong-un's Grandfather, Kim Il-Sung. These anniversaries usually accompany big celebrations - there is a chance this could be the date that North Korea makes its move.
A land attack into the South is unlikely, as it would most likely lead to US retaliation, which could crush the current regime, instead it may be test a nuclear weapon. Either way, all eyes will be on the region in the coming days and any attack, in whatever its form, could cause a reaction in the markets.
We think the most at-risk assets include the dollar, the yen, US Treasuries and stocks, especially Asian stocks. The yen could stage a sharp reversal as it may attract huge safe haven flows on the back of an attack from North Korea, US Treasuries and also the dollar could surge as investors search-out the world's most liquid assets. The South Korean equity market could fall even further; the Kospi is already down more than 5% since peaking in March. However, the Nikkei could also be at risk. The Japanese index has been a huge beneficiary from lose monetary policy from the Bank of Japan, and it has surged an enormous 50% since November. Any sign of yen strength fuelled by North Korean military aggression may give investors the excuse they have been looking for to sell this index at these lofty levels.
Over the next few days North Korean actions could generate some volatility in global asset markets and investors may turn more cautious as we edge closer to the 10th and 15th April, key dates for Pyongyang. However, we think the long term impact of any North Korean aggression will be minimal and Kim Jong-un has more bark than bite. Thus, any sell off in risky assets or a surge in value in the yen could be used as an opportunity by canny investors.
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