Donald Trump and Kim Jong-un: how does the US and North Korea impact markets?

The constant struggle between the US and North Korea poses the biggest threat to the Korean Peninsula and has embroiled South Korea, Japan, China and the wider Asian region for decades. But what threat does it all represent for the global economy and international financial markets?

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Source: Bloomberg

‘To North Korea, diplomacy is another form of war,’ - Brian R Myers, author of Stranger than Fiction, 2005.

The Korean War was active between 1950 and 1953, and is technically the longest-running war ever, as a peace treaty has never been signed. Battle only halted after an armistice was declared by the multiple nations involved, and modern-day Northeast Asia has been shaped by the tense times that have panned out since.

While the story behind the Korean Peninsula does deserve in-depth coverage, in short, the country was not able to unify because of the many foreign powers at play. Korea was a Japanese colony until 1945, but by the end of World War Two the country was occupied by both the US and Russia, which agreed to temporarily divide Korea along the 38th parallel, to split Korea in two.

This then sparked different views on how Korea should be governed amongst its own people, with the North having evolved a Soviet-based model while the South moved toward capitalism, ultimately sparking the Korean War. This saga is Korea’s deepest scar and the root cause of the dangerous tension that lingers today on the Peninsula.

How do you solve a problem like Korea?

North Korea revealed its nuclear capability when it conducted its first nuclear test in 2006. Multiple tests have been carried out since, growing in magnitude each time, and the country successfully carried out its first test of a hydrogen bomb in 2016. While facts from North Korea are thin on the ground, it is clear that its nuclear capability is improving and its missile systems are becoming increasingly competent.

Tension between the US and North Korea escalated quickly after the latest test carried out last year, with leaders publicly exchanging threats, particularly after North Korea threatened to hit US military bases in Guam. President Donald Trump and Kim Jong-un flung insults at each other, and at one point the pair were even talking about whose nuclear button was bigger.

As quick as it escalated, tensions have subsided throughout this year and now it looks more likely than ever that some form of talks between the US and North Korea could take place, which would build on landmark meetings between the North and South as well as the collaboration at the recent Winter Olympics in Pyeongchang, which saw a ‘unified Korea’ compete on the world stage.

What are the possible outcomes for US and North Korea?

The world is far from solving a problem like Korea and the issue will continue to cast a large shadow over an otherwise buoyant northeast Asia.

Ultimately, there are three scenarios that could pan out, all of which would yield very different outcomes for the world, its economy and financial markets. These are:

  1. Military conflict
  2. Resumption of dialogue between the US and North Korea
  3. The current status quo continues - this a grey area between the first two options with sanctions playing an increasingly important role in the stand-off

Let’s have a look at the many forces in play, the potential impact on the economy and how global financial markets could be impacted by any outbreak of war.

Kim Jong-un: North Korea

‘The military might of a country represents its national strength. Only when it builds up its military might in every way can it develop into a thriving country,’ – North Korean leader Kim Jong-un, 2013.

North Korea justifies its nuclear arsenal as a necessary deterrent against what it perceives as US aggression, without which it would be vulnerable to invasion by its Southern neighbours as its allies.

Increasingly isolated from the world, North Korea’s trade is predominantly with China. While sanctions have changed since, data from the Observatory of Economic Complexity (OEC) suggests that 83% of North Korea’s exports went to China in 2015 (mainly coal, metals, petroleum and clothing), while 85% of the North’s imports came from China.

While Kim and the North look more open to holding a face-to-face meeting with the US than ever before, it will be a ‘believe it when you see it’ moment.

Donald Trump: US

‘One way or the other, we have to do something. We cannot let the situation fester. We cannot let it happen,’ – US President Donald Trump, 2018.

Sanctions have been the main weapon used against North Korea, led by calls from the US. Since the North withdrew from the Nuclear Non-Proliferation Treaty in 2003, the UN Security Council has always opted to use economic starvation as its way to respond, first introducing sanctions in 2006 and subsequently expanding and strengthening on several occasions since. The most recent sanctions imposed late last year placed new restrictions on the country’s oil imports, and metal, agricultural and labour exports.

Trump has interacted with the North Korean situation more than his predecessors, who traditionally have avoided the negotiating table in the hope that patience, tighter sanctions, and leaning on China’s influence would eventually prevail.

The US president is willing to talk to North Korea, but at the same time is equally ready for military action if needed, and is less inclined to use China as a way to deal with the North. Their relationship with China, whether it be on North Korea or trade tariffs, is another risk.

US defence stocks, as well as tech companies, offering cyber defence products would be a beneficiary of any heightened tensions or conflict. The US government was spending the equivalent of 4.2% of gross domestic product (GDP) on defence spending at the peak of the Korean War and the total cost of the second Gulf War in 2003 was thought to be equal to 5% of annual GDP.

Read more: is it time to look at defence stocks?

US federal debt, already at 105% of GDP, would rise in the outbreak of war.

Moon Jae-in: South Korea

‘The problem of resolving the issues in the Korean Peninsula should be led by South Korea and helped by our neighbouring countries such as the United States, which is our leading ally,’ – South Korean Prime Minister Moon Jae-in, 2017.

North Korea evokes very mixed emotions in the South. While the South would form the epicentre of any outbreak of war, the support for reunification is still very real, even if this is withering as generations pass by. Bringing peace to the Peninsula is a priority for Moon, and his biggest challenge is maintaining control and ensuring the South remains the middleman between the US and the North, to avoid being the biggest casualty of a war it didn’t want.

The US is integral to South Korea, but there is also growing concern from South Koreans over the US military presence, demonstrated by protests when the US deployed a missile defence system last year (much to China and Russia’s displeasure). The US has about 35,000 personnel in the country.

Conflict would see a huge sell-off in South Korean equities and bonds. The country’s business and consumer confidence would fall sharply and risk on South Korean assets would rise. This would ultimately lead to weaker demand in the country and a severe deterioration in credit conditions.

South Korea represents around 2% of global GDP and the effect would spill over to hit Asian and global growth. The South Korean won would also depreciate against the US dollar, as it has done when the threat of conflict has risen previously.

Shinzo Abe: Japan

‘Indeed, to all appearances, Japan — not North Korea — stokes the most passion in South Korea today. That’s tough for outsiders like yours to truly fathom,’ – James Holmes, author of ‘Why Korea Still Fears Japan’, 2015.

Japan has always been the frustrated outsider throughout the stand-off. There has been plenty of bad-blood between the nation and South Korea since Japanese occupation, which in turn resulted in international pressure being placed on Japan’s military capability – a constraint that has only recently loosened.

With Japan having to watch North Korean missiles soar over its land, the country’s biggest fear is being cut-out of any negotiations and subsequent deal struck by the South, the North and the US. Japan’s ability to form any tight-knit relations with China has also been limited, because Japan has had to naturally align itself with the US in the region over recent decades. There are more US personnel in Japan than in South Korea, closer to 40,000.

Japan has supported dialogue with North Korea, but President Shinzō Abe has also been the leading supporter of Trump’s ‘maximum pressure’ campaign against the hermit nation, which has prompted North Korea to warn that Japan may lose its invitation to any talks – poignant when discussions about tri-lateral talks between the South, North and the US look more likely than ever before.

The concern for markets is the inevitability that Japan, with 40,000 US troops and multiple air bases, would be dragged into any conflict in the region. There would be a sharp sell-off in equities, and business and consumer confidence knocked.

The yen has an interesting relationship with tension in the region. Mainly because of the size of Japan’s foreign assets, the yen is considered as a safe haven during uncertain times, much like gold. The world’s third most-traded currency offers a trade-off between its strong track record when global risk is high (rallying against the US dollar) and the possibility of Japan being struck by a missile, the latter of which may see more demand shift to other safe-haven currencies like the Swiss franc.

Domestic demand would suffer if equity prices decline and confidence is knocked, and foreign demand for Japanese goods would be hit by a stronger yen and any slowdown in growth in the wider region.   

Xi Jinping: China

‘If China is not going to solve North Korea, we will,’ – US President Donald Trump, 2017.

While China has more ability to influence North Korea than any other by being its biggest trading partner, it can be argued that China is the only country in the mix that actually wants to maintain the status quo.

With such a heavy US military presence in South Korea, China regards the North as an important buffer protecting its border. This was one of the reasons China supported the North during the Korean war, which represents the most direct battle in modern warfare between the US and China.

The situation is a bit of a double-ended sword for China. The US uses North Korea to justify its military presence in the region, but China does not believe that would change if Kim was overthrown. The country is not totally comfortable with having North Korean nukes on its borders, but is much more concerned about the US redeploying nukes in the South (having removed them in 1991 after 33 years).

Stock markets are used to the threat of North Korea ever-looming, but money does flood to safe haven assets as tensions rise. With the exception of military conflict, the relationship between US and China poses risks to the market. If the North ramps-up tension between the two powerhouses, Chinese equity prices would fall, while the US would only experience a ‘limited impact’, according to Capital Economics.

Because China is the world’s engine of growth, weaker business and consumer confidence would raise the risk attached to global emerging markets, particularly in Asia as the entire region becomes unstable. Depending on how entangled China became in any clash with the US, there would be (at least) a temporary knock on domestic demand as asset prices fall, which would spread to other emerging markets in Asia.

How could conflict with North Korea destroy global supply chains?

Even if conflict somehow managed to be contained in Korea itself, the impact on global supply chains would be substantial. South Korea is the sixth largest exporter of intermediate goods, and nearly all of the countries that export more would be involved in any outbreak of war.

Multiple industries face potential disruption in South Korea. A tenth of the country’s exports are microchips made by the likes of Samsung, which also supplies the likes of Apple. South Korea is a dominant supplier of products like LCDs, automotive parts and homes three of the world’s biggest ship builders.

According to OEC data, South Korea’s top exports in 2016 included:

Product % of total experts
Integrated circuits 10%
Cars 7.7%
Passenger/Cargo ships 5.2%
Refined petroleum 5%
Vehicle parts 4.5%
LCDs 3.3%

 

It is worth noting that any drag on export growth, short or long-term, would also impact production capacity in Asia as supply availability changes.

Conclusion

The stand-off between the US and North Korea is likely to continue for the foreseeable future, and strain relations between the other major players like South Korea, China, and Japan. Assets such as gold and currencies like the Swiss franc will continue to attract investors when the world gets nervous, and the yen will also retain its safe haven status and offer potential over the dollar during times of uncertainty. The South Korean won will continue to take hits from any heightened threat.

The majority of risk to equities lies in Asia, but all US and European stocks that share close ties with Asian suppliers or customers would also be in for a severe shock. If the status quo is maintained but tensions continue to rise, then defence and cyber defence stocks should see a trend of increased activity.

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