North Korea’s recent successful test of a missile capable of reaching much of the US mainland is clearly a concern but it is not because such an attack is imminent or likely. The history of military rocket development suggests that it will still be some years before North Korea could be assured of a successful, let alone multiple, strike on the US or even Guam. However, in the event of any attack, the overwhelming superiority of US forces would undoubtedly ensure the destruction of North Korea. Therefore in many respects Trump’s most aggressive comments this week were a statement of the obvious and investors should accordingly not over-react, even as volatility has risen during thin trading over the holiday season.
The game which is being played is nevertheless increasingly tense due to North Korea’s large conventional forces which act as a deterrent to any pre-emptive military action aimed at halting its nuclear and missile development program. It is the integration of nuclear and missile technology which is the threat; in World War II enormous resources were ploughed into the German V2 rocket system rather than fighter aircraft, but the military impact of the rocket alone was minimal. Though it is likely to be a few years before North Korea can put into production a missile system of sufficient scale and accuracy to be a meaningful threat, the US and international community is clearly in a very difficult position.
The North Korean weapons development program has been on this track for decades and this problem is not one of Trump’s making. However, it is obvious why investors are concerned that it has come to a head with such a volatile US President, who currently has authority to launch a nuclear attack without reference to the US Congress should he wish to.
Excluding the Trump factor, investors would normally now expect the international community to coalesce around an initiative to restrain the further development of North Korea’s missile and nuclear warhead capabilities through the use of diplomacy, sanctions and incentives for compliance. It is clear the direct risks of an escalation are far higher in South Korea, China and Japan than in the West and such nations will have strong views on how to proceed. In this respect the Chinese and Russian support for UN sanctions last week was encouraging.
Therefore, our base case is that there is an escalation of rhetoric only, even if it is likely to persist for some time. For Trump, deflecting attention from his struggling domestic agenda with a foreign policy crisis is likely to support his flagging approval rating, which has risen from 38% to 44% in the last 10 days. For North Korea the optimal strategy seems to be to continue to play for time as its developing nuclear and missile capacities only improve its negotiating position.
A US-led pre-emptive strikes on weapons facilities risk a major conventional conflict in the region with no guarantee of halting the weapons program and as such appear to be a poor risk/reward. Further diplomacy is likely to be tried first. Therefore, despite the rhetoric, the probability of any actual military action remains very low and the uneasy peace which has lasted 60 years is likely to continue. Hawks may complain tough talk and no action represents “kicking the can down the road” but this may suit domestic politics on both sides, and still be the least bad option.
For global investors, the events of the last few weeks are a reminder that geopolitical issues can be important even if they develop over decades before erupting into the foreground. However, we have previously identified a number of rather ordinary factors – such as weakening earnings momentum, Brexit uncertainty in the UK, tighter US monetary policy and high equity valuations – as reasons to be cautious on equity markets. All these factors remain in place and our outlook remains cautious, even after the modest declines in equities in the last week.