Northern Exposure: Assessing the North Korea threat
The situation in North Korea has shifted from being a chronic but manageable irritant for most global leaders, to a growing geopolitical crisis that threatens to escalate tensions between the US and China, the two largest economies in the world (who also just happen to have two of the most powerful military forces in the world).
How did things ever get to this point, what is likely to happen next, and how should investors position portfolios, are all questions that now beg to be answered.
Let’s start with how we got here
While tensions on the Korean peninsula have clearly escalated over the past several years, this is a conflict that has been festering and periodically flaring since World War II. The decision by the US and USSR to divide the Korean Peninsula along the 38th parallel assured that a near permanent state of tension would exist in northeast Asia. Even the fall of the Berlin Wall, collapse of the Soviet Union, and opening up of the Chinese economy failed to alter the status quo.
Keep in mind that the Korean War ended not with a formal peace treaty, but instead with an armistice. So for those north of the border, under the dynastic rule of the Kim family, an effective “state of war” with South Korea and the US is still seen to exist. This has prompted North Korean leaders to develop weapons of mass destruction to preserve their own despotic reign. But it was the recent progress in both ballistic missile technology and warhead miniaturization – coupled with the more assertive and confrontational approach taken by the Trump Administration – that have once again pushed tensions on the peninsula closer to the boiling point.
So what happens next?
Based upon conversations with our own risk analysts, senior congressional leaders, and geopolitical experts, it would appear that there are three potential courses of action: military intervention; acceptance of the status quo; diplomatic solution that includes an expansion of economic sanctions.
The military option is complex and fraught with peril. Even if the US were to attempt a limited or targeted strike against Pyongyang's nuclear capabilities, there is a significant risk of escalation with devastating consequences. The theatre of action would quickly expand, likely enveloping China, Japan and South Korea. It could not only trigger one of the bloodiest conflicts since the end of the Cold War, but could also unleash a catastrophic refugee crisis. We therefore view a military strike more as a "last resort" rather than a viable "first option."
Acceptance of the status quo would require the US, South Korea and Japan to not only assent to the recent progress made by the Kim regime in developing weapons of mass destruction, but also acknowledge that further enhancements to these capabilities are inevitable. Based upon statements by the Trump Administration – as well decades-long official US policy – this would simply be an unacceptable option. It would not only leave key US allies in the region vulnerable to direct military threat, but could also expose both the US military and private citizens to attack over time.
This suggests that diplomacy coupled with a ratcheting up of economic sanctions is the "least worst" option available for trying to deescalate the crisis and therefore also the most likely outcome. Kim Jung Un has not responded well to diplomatic outreach alone, nor has a unilateral expansion of economic pressure by the US proved to be effective. But the current approach that allows for diplomatic engagement, while also expanding sanctions in cooperation with China and Russia through the UN, could be more successful. Of course, it depends to a great extent on China's ability and willingness to play an active and engaged role in reining in Kim's nuclear ambitions.
How should portfolios be positioned?
To be clear, we still see a further material escalation of tensions on the Korean peninsula into outright military conflict to be a low probability "tail risk" event. It has long been our view that there are three potential stages to the crisis: (1) stability; (2) temporary escalation; (3) permanent and progressive escalation. We have clearly proceeded from stage one to stage two with these most recent developments, but still consider a progression to stage three as unlikely. Accordingly, we have raised our risk assessment from "very low" (less than 10 percent probability) to "low" (10-20 percent probability). We therefore opt to retain our current overall pro-risk stance with an overweight to global equities.
Keep in mind that temporary escalation, and then easing, of geopolitical tensions, is a fairly common occurrence historically.
Markets typically respond initially with increased volatility, but quickly normalize as tensions ease – especially when economic growth dynamics are unaffected. Since a temporary flaring of tensions on the Korean peninsula would not meaningfully alter global growth prospects, we would expect risk assets to quickly stabilize by responding to the solid fundamental and policy drivers still in place.
We will, however, continue to monitor developments on the ground and make any tactical shifts we deem prudent if we believe that the crisis is progressing from stage two to stage three. This could include an overall "derisking" of the portfolio, a reduction in direct regional exposure, or initiating active hedges. But in the meantime, one of the best ways investors can help protect against being overexposed to geopolitical event risk is to maintain a welldiversified portfolio that consists of both cyclical and defensive market segments as well as riskfree assets. This sort of "evergreen" prudent approach best serves to preserve wealth during episodes of heightened geopolitical risk such as this.