War games

Tensions have risen sharply on the Korean peninsula this year, as North Korea (NK) has accelerated the pace of rocket launches and has conducted its sixth nuclear test. In response, the United Nations has adopted its strongest sanctions yet, but the fault lines remain. The measures, including an embargo on textiles exports, a ban on employing additional NK workers overseas and a cap on refined petroleum trading, won support from China and Russia. But this was only after stronger proposals circulated by the United States were watered down. Ahead of the UN vote, NK remained defiant, attacking the US as a “blood-thirsty beast”.

The most likely “Korean conflict” scenario is, in our view, a fast-escalating accident. A deliberate strike by either the United States or NK seems highly unlikely. It would be all but impossible for the US to identify and eliminate all of NK’s military facilities in a first strike, risking a rapid escalation that draws in China. For NK, even if it were to overrun South Korea’s (SK’s) defences by sheer numbers in a sudden attack, it would be seriously technically disadvantaged in a joint SK/US response and China’s patience could be worn to breaking point.

What lessons can we draw on to help navigate the choppy investment waters around the Korean peninsula?

In the current atmosphere, however, a localised exchange of fire could provide the catalyst for an accidental conflict. In this scenario, NK could be defeated in a relatively short-lived campaign (lasting months rather than years), reflecting US/SK military superiority. But a short campaign is far from guaranteed. The 2003 Iraq war was expected to last a matter of weeks or months; US military personnel finally left in 2011. Investors will worry that even a short-lived engagement has the potential for substantial economic and market impacts. If NK were able to set off a nuclear bomb in SK, the consequences could be greater still. So the potential for conflict looks set to weigh on investors’ minds for the foreseeable future. What lessons can we draw on to help navigate the choppy investment waters around the Korean peninsula? Here are three.

Lesson 1: Market responses can be rapid … and safe havens matter

In the ten largest episodes of tension on the Korean peninsula in recent years – including NK’s nuclear tests, border skirmishes and President Trump’s “fire and fury” comments – SK, Japanese and Chinese equity markets fell by an average of 2-2.5% in the following five business days, while the price of gold rose by a similar magnitude. This flight to safe havens was echoed in currency markets, with the Korean won falling by around 1.5%, while the Swiss franc and Japanese yen both rose by around 0.75%. The market response may have been rapid, but it was also short-lived: even for SK assets, markets retraced their losses within an average of five business days as tensions dissipated.

Investors moving out of regional assets with direct exposure to any potential conflict and into perceived safe havens may seem intuitively obvious, but what about the yen? After all, Japan is well within range of NK’s missiles. The country’s alliance with the US could also make it vulnerable to attack. So a move by investors into, rather than out of, the yen may seem surprising. They could be anticipating (correctly, to date) both limited Japanese involvement and little disruption to trade flows. Japanese investors could also be reducing their exposure to overseas investments against a backdrop of anticipated currency-market volatility.

The yen’s safe-haven response to rising Korean tensions also tallies with other, non-conflict, “Japan-specific” shocks. Take the March 2011 East Japan Earthquake – a 9.0-magnitude quake so powerful that it moved Honshu, Japan’s largest island, 2.4 metres to the east. It shifted the Earth on its axis by between 10-25 centimetres. The tsunami that followed shortly after directly impacted a continuous stretch of land more than 500kms in length, with a maximum wave height of 38 metres. Following the earthquake and tsunami, an accident at the Fukushima nuclear power plant resulted in an incident on the International Nuclear Event scale at Level 7, the highest possible. The yen appreciated 5% in the week after the catastrophe, only reversing course after the G7 central banks intervened jointly to weaken it. The initial move looks to have been driven by the perception that Japanese firms and insurers would repatriate funds to pay for reconstruction. A similar pattern could emerge in the event of war.

On the basis of Lesson 1, therefore, we would expect a significant short-term market impact from our “fast-escalating accident” scenario. Equity markets would initially fall sharply, accompanied by abrupt currency and bond-market adjustments. In general, asset markets would follow the pattern of recent episodes in the region, with flows into safe havens including (despite Japan’s geographical vulnerability) the yen. With conflict resolution, however, market prices could rebound fairly swiftly.

Lesson 2: Dig beneath the macro-level data

SK is the world’s ninth largest economy, accounting for around 2% of global GDP, so any hit to its growth rate would have a knock-on effect to global activity. But investors should look beneath the macro-level data to gauge the true scale of vulnerabilities: In this case, to SK’s role in global supply chains. As the 2011 Thai floods showed, just-in-time delivery systems have made companies very vulnerable to supply-chain disruption – with automotive and electronics companies reporting shortages for months after the floods receded. As SK exports around three times as many intermediate goods as Thailand, the disruption would likely be far worse. SK is the world’s fourth-largest producer (by value added) of electronics; the world’s largest producer of liquid crystal displays (40% market share); and the second-largest producer of semiconductors (17% market share). It is a key supplier for electronics companies globally, including Apple. As a result, temporary global product shortages and higher prices could ensue.

Lesson 3: Effects can be long-lasting

Even in a “fast-escalating accident” scenario with reasonably swift conflict resolution, the hit to economic activity is likely to persist beyond the market effects. This is partly because growth rates will be impacted not only by the direct effects on SK’s economy, spill overs to China and Japan, the potential for disruption to global supply chains and the drag on export growth for key trading partners, but also by the financial and wealth effects of the (relatively short-lived) shock to global asset markets. All told, our simulations indicate that global GDP growth could slow to 2.6% in 2018 and 2.4% in 2019, compared with 3.0% and 2.8% in our baseline.

Looking further ahead, if military conflict were to lead ultimately to the end of Kim Jong-un’s regime, it could bring the reunification of NK and SK a step closer. The North’s population is relatively young, which would improve SK’s poor demographic outlook. Most of the peninsula’s natural resources lie in the North, which would reduce SK’s dependence on importing raw materials. But the economic costs of reunification would be vast. Recent experience in Iraq and Libya suggests that the impacts of regime change can also be unpredictable. Not least, how would China respond? Even equipped with our three lessons, therefore, a steady eye and strong stomach are likely to benefit investors during the inevitable squalls.

Lucy O'Carroll
Chief Economist, Aberdeen