Investment implications arising from North Korea's nuclear programme

We give our view on this ongoing concern

What has happened

North Korea escalated the tension in East Asia by its apparently successful test of a nuclear warhead on 3rd September. It puts North Korea closer to becoming a nuclear power, something that would destabilise the peace that has held on the Korean peninsula since 1953.

In response, President Trump has this week encouraged South Korea and Japan to buy more military equipment. The US also wants the United Nations to approve tough economic sanctions against North Korea on September 11th. However, this may be opposed by China and Russia, both of whom see benefits from the existence of a North Korea that is hostile to the US.

Despite this serious geopolitical situation, financial markets have been calm. For example, the South Korean won has barely moved against the Japanese yen in recent weeks as the chart below shows. During the Asian financial crisis of 1997-98 and the financial crisis of 2007-09 the won declined over 50% against the yen.

Korean won per Japanese yen graph

Source: Bloomberg, Waverton. Data from 10.01.97 to 01.09.17

We believe the market reaction is rational

There are several reasons to think the market reaction is rational.

First, while North Korea may be able to test a nuclear weapon underground, that is a long way from being able to launch the weapon and strike a target far away. Los Angeles is 5,935 miles from Pyongyang, London is 5,379 and Guam is 2,114.

Second, the US may want to conduct some form of bombing campaign to neutralise the North Korean nuclear facility but doing so without the support of South Korea and Japan would be highly risky.

  • South Korea has no desire for armed conflict. Seoul is 35 miles from the North Korean border and conventional North Korean artillery is aimed at Seoul. North Korea could also attempt an invasion of South Korea. That would pit the fourth and seventh largest armies in the world against one another, a war on a scale not seen since Vietnam.
  • North Korea has threatened Japan having launched a missile into the Sea of Japan on August 29th. It could therefore also launch one at Tokyo, for example, were the US to take any action against North Korea.

Third, the US would also alienate China were it to take military action. China is the primary supporter of North Korea, supplying 90% of its energy needs (Russia supplies the other 10%) and is its primary trading partner. China wants a divided Korean peninsula as the North provides a buffer between it and the US allied South Korea. However, China has significant economic interests in retaining peace on the peninsula. It certainly does not want to be in a war with the US, its key trading partner.

Given all the above, it seems difficult to believe that responding to the North Korean nuclear threat with militarily action is likely to happen.

Risks to our core view

We see three major risks to our core view.

First, the possibility of irrational action by North Korea cannot be completely discounted.

Second, US policy responses could be damaging to market confidence. For example, there has been talk of the US imposing trade sanctions on China in an effort to get China to in turn to support economic sanctions on North Korea. Given the trade linkages between the US and China such a move would be highly destabilising and could create a global economic downturn.

Thirdly, we are currently in the position where North Korea is developing a nuclear weapons programme. If we get to the point where western intelligence is convinced North Korea has developed the capability to launch a nuclear bomb at the continental US then the judgement about what is rational changes. The US could then decide the need to eliminate that North Korean capability is paramount, even if in doing so it risks a reaction that imperils South Korea and Japan. After all, were North Korea to have a functioning nuclear arsenal and the US did nothing, the risk of the proliferation of nuclear weapons across the globe increases exponentially. That would raise the geopolitical temperature to the point where the markets would likely react.

Conclusion

While alert to the risks, we are not changing our core positioning because of the Korean situation. A peaceful resolution would enable the focus to remain on the fundamental backdrop and on the valuations of financial assets. Analysis of those factors continues to lead us to see investment opportunities, primarily in the global stock market.

By William Dinning

Head of Investment Strategy and Communication

As at 06.09.17

Risk Warnings

The views and opinions expressed are the views of Waverton Investment Management Limited and are subject to change based on market and other conditions.  The information provided does not constitute investment advice and it should not be relied on as such.  All material(s) have been obtained from sources believed to be reliable, but its accuracy is not guaranteed.  There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information.

Changes in rates of exchange may have an adverse effect on the value, price or income of an investment.

Past performance is no guarantee of future results and the value of such investments and their strategies may fall as well as rise.  Capital security is not guaranteed