Global Research: Special Report

The short and long term market impact of North Korea’s missile launches

This special report from J.P. Morgan’s Global Research Unit, which can also be found on J.P. Morgan Markets, offers a look at the market implications from rising geopolitical tensions with North Korea.

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In the aftermath of North Korea’s recent nuclear test and intercontinental ballistic missile launches, the risk of broader-scale military conflict is clearly rising. On September 11, the UN Security Council unanimously passed an Executive Order on North Korea that implemented a limit on oil imports, a ban on textile exports, ended overseas laborer contracts, suppressed smuggling efforts, ended joint ventures, and froze the assets of North Korea government entities. Building on these sanctions, the White House also issued an Executive Order on September 21 that would penalize any U.S. company or person that engages with North Korea as well as the financial institutions that facilitate this trade.

Over the past decade, North Korea has generated many false alarms with each incident generating modest market reactions. But the actual situation is likely becoming more serious than markets perceive, as tensions around North Korea contribute to market volatility in otherwise calm markets. Geopolitical anxiety looks extremely high as measured by the Geopolitical Anxiety Index (GAI) launched by J.P. Morgan’s Global FX strategy team to track complacency and fear. Heightened military alerts will likely endure until possible options of stricter economic sanctions are depleted, including secondary boycotts to sanctioned entities that are trading with North Korea.

Economic View

The market has had a fairly muted response that reflects the low perceived probability of serious military conflicts, but tensions could rise further as North Korea continues to develop its nuclear program. Depending on the U.S. and its allies’ response to the issue, there are three potential scenarios:

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Military conflict

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Resumption of direct dialogue between the U.S. and North Korea

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A grey area between the first and second scenarios, which is the status quo with increasingly stricter sanctions

With North Korea’s development of ballistic missiles and its nuclear program becoming increasingly real, J.P. Morgan’s Global Research Unit has concluded the most likely near-term scenario would be that the U.S. and its allies would muddle through the situation, along with heightened military alert, until they deplete all the possible options of stricter economic sanctions including secondary boycotts to sanctioned entities that are trading with North Korea.

Emerging Markets View

U.S. market sentiment has been impacted by the geopolitical tensions in the Korean peninsula and risk aversion could still rise further regionally and globally if tensions eventually lead to military confrontation. In this case, the equity and currency markets for the EM Asia markets would immediately become impacted. Foreign holdings of Asian equities have risen an estimated $500bn – or just over 2% of regional GDP – since the start of the year,with Korea accounting for close to 25% of this rise.

U.S. Credit View

U.S. high grade bond spreads should markedly widen if the North Korean situation materially deteriorates. First, lower Treasury yields usually lead to wider corporate spreads and these spreads would also likely lead to a flight to quality, negative for risky assets. Ultimately, the credit market reaction would likely be felt relatively evenly across sectors but domestically focused companies may fare better than the more global ones.

Asset Allocation

Cross asset market movements have been relatively muted with few signs of hedging rising geopolitical risk. Risk markets have been in a holding pattern the last few months, with the growing political uncertainty and noise from Washington and North Korea holding in check the positives from stronger economic activity data. As both implied and realized volatilities increased modestly over the past month, North Korea has been added as a source of volatility for markets in addition to impending central bank meetings.

FX View

Should tensions escalate, the dollar’s performance will likely vary by pair. Due to deleveraging, the dollar is quite likely to rise versus high-yield/commodity currencies that investors are long, and fall versus currencies like the yen that accounts are short. The euro will benefit intermittently as an alternative reserve asset to the dollar in a conflict involving the U.S., thus keeping the EUR/USD broadly stable. The yen would likely strengthen if the conflict extended to Japan, mainly due to deleveraging by investors. However, the possibility of direct damage to Japan – given its geographic proximity – in the event of an armed conflict has not been ruled out.

Equity View

Many equity investors view North Korean nuclear and missile tests as part of a long standing policy. The impact of geopolitical tensions is mainly on Korean companies exposed to Chinese demand rather than specific sectors. Boycotts of Korean goods, in response to the installation of its Terminal High Altitude Area Defense (THAAD) anti-missile system, have hit auto and luxury goods plus Chinese tourist arrivals. Lastly, North Korea’s actions may add to the trend of higher defense spending, notably on anti-missile technology.

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View report on J.P. Morgan Markets

A senior analyst involved in the preparation of the content of this report has a household member who is a senior portfolio manager of and investor in certain emerging markets mutual funds, which may invest in instruments discussed in this report.

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