North Korea tensions a key watchpoint for markets

Tensions around North Korea remain elevated. Negotiations between the US and North Korea continue on, with US Secretary of State Rex Tillerson stating that 'negotiations will continue until the first bomb is dropped'.

Our expectation is that we will see tensions reach a peak, and then a move towards de-escalation. This would be similar to the situation that was seen with the Iran negotiation, where tensions were high in 2012 as the Obama administration ramped up its rhetoric about Iran's nuclear program, before easing as negotiations led to the Nuclear accord.

This would see a new uneasy 'normal'. China is likely to remain aligned to North Korea, while South Korea may potentially pivot at the margin from US to China.

There was a lot of speculation that there would be a missile test on the week of 9 October 2017 to mark the Party Foundation Day (the anniversary of the founding of the Worker's Party of Korea in 1945). The North Korean regime did not do any form of missile test, and we suspect this is in part due to sanctions taking place. China has implemented sanctions on the import of iron ore, coal and textiles, a tougher response than we would have previously have expected. Chinese imports of iron ore, coal and textiles accounts for around 65% of North Korean export earnings. China have also implemented sanctions on the export of petroleum products to North Korea, although we think this has been less impactful as exports of crude oil have not been changed (meaning the North Korean regime are able to divert oil to military and official use).

The key watchpoint to see the effectiveness of these sanctions will be this week (16-20 October 2017) with the United States and South Korean military conducting joint naval exercises in the region. There has been speculation that the North Korean regime is planning another missile launch, which could suggest that we are still reaching the peak of tensions. With every missile test though, there is the tail risk that we enter military conflict, which would be accompanied by a sell-off in global equities. Many of the obvious 'safe-haven' assets are already expensive in our view (including US Treasuries, US Dollar and the Swiss Franc). Gold stands out, in our opinion, as offering better value if we were to see conflict on the Korean Peninsula.

In the very short term, currently heightened Korean tensions provide information on the fragility or otherwise of equity markets. The ability of Wall St to simultaneously shrug off, not only thermo-nuclear detonations, but also White House dysfunctionality and some disappointment in economic data, in early September, in our view speaks to a relatively healthy tone to US equities. Put another way - if the market were fundamentally weak and at risk, there have been plenty of opportunities already for a downtrend to develop.

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