New article from Tatton Investment Management: Stocks take note of North Korea crisis - or do they?

11 August 2017

Over the week, the main global stock markets fell by between 2 and 3.5% and thereby finally appeared to acknowledge the heightened geopolitical risk levels emanating from the nuclear showdown of words between North Korea’s dynastic leader Kim Yung Un and US president Donald Trump. That at least is how the market media was very quick to conclude.

We would agree that the North Korea crisis was the catalyst for the mini sell-off in a market environment that has been fraught with talk of an imminent stock market correction for reasons of overvaluation, looming bond market collapse or economic downturn around the corner. In situations like this, any half-rational justification ‘will do’ to persuade the ‘fast money’ that there should be more sellers than buyers in the market. 

To us, what was more important to observe is how relatively calm they remained. The positive, rather than negative sentiment that has reigned ever since the Brexit vote, once again persevered. Major ‘flight to safety’ moves in the currency markets did not happen and by Friday evening, US stock markets had turned around already.

If we assume the markets are right and there is no imminent threat of an outbreak of (nuclear) hostilities between the US and North Korea, then this could be because of a number of reasons.

Firstly, the current shouting match may be seen as no different to those we have witnessed over the years and just as they didn’t come to anything, neither will this one – another storm in a tea cup.   We would somewhat disagree: The western world will want to prevent North Korea from acquiring transcontinental nuclear arms capability and ratchet up pressure, just as they did with Iran. This pressure point is therefore not going to just turn into another frozen conflict, but likely to become worse over time.

Secondly, markets may assume that this is not as serious as it sounds, because North Korea is no longer enjoying the irrevocable support of China. It is therefore a rather irrelevant skirmish between an underdeveloped, rogue state with an economy of a GDP size that their opponent and eminent leading world power annually spends on pet care.   This may be closer to what is actually going on. It is important to note that the whole shouting match only started at the beginning of the week, after the UN Security Council passed further sanctions against North Korea – with the support of China(!).

Thirdly, the probability that this conflict will cause some damage in Asia may be rising, but the fact that it appears to be binding the US and China closer together should be more positive, than any collateral damage would be negative.  While cynical, this is probably also a contributing factor to the relative calm, even though it overlooks that China’s interests are far more complex relative to North Korea than those of the US. They neither want to face a refugee crisis, nor would they want to suddenly have a common border with united Korea that aligns itself closer to the US, than China.

Our own view is that there is a possibility for this conflict to escalate over the coming weeks, however, we ascribe a higher probability to this happening much further in the future. In the meantime, we are pleased to see that the US has once again taken a back-step to triggering an unhelpful trade conflict with China.

In summary, we are reassured by the measured market reaction to what could escalate into quite a nasty military conflict. At the same time we note the nervousness of the markets which, as we have anticipated for a while, are increasingly uncomfortable about the valuation levels they have reached on the back of quite reasonable economic growth in combination with too loose a monetary environment.

Only once central banks in a more concerted effort begin to scale back their monetary support from the autumn onwards, will we know whether general market confidence has become strong enough to substitute the monetary ‘crutches’ with genuine positive sentiment. As central banks appear determined to head down this road we will find out sooner rather than later whether the monetary accelerators of re-awakened economic animal spirits will be sufficient to carry this cycle further.

Our central case is that yes, after an initial period of doubt and volatility the global economy will plough on – albeit with the possibility of heightened levels of price inflation further down the line.

Regarding the asset returns table for July at the top, it is probably looking better than it actually was. This is because June had ended on a low after the mini market tantrum over the central banks’ coordinated announcements that they will begin to reduce monetary support across the board. As a result, the year to date return figures are merely back to where they stood already at the end of May. Nevertheless, just like the North Korea episode this week the bounce back of asset markets during July is reassuring for investors as it indicated that there is considerable resilience in the positive turn of sentiment that we have now experienced for more than 12 months.

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