North Korea's nuclear bomb test on Sunday, coming on the heels of its earlier ballistic missile launch over Japan, along with the Trump administration’s tough talk in response, rattled global stock market investors. Most markets across Asia declined on Monday following the missile test. Japan's Topix index ended the session 1% lower, while South Korea's Kospi index dropped 1.2%. Hong Kong's Hang Seng index declined 1%, although, surprisingly, China’s Shanghai index actually rose. The Philippines index also rose. Overall, however, markets across Asia sold off. The MSCI Asia Pacific Index fell 0.6%. Japan and Korea declined again on Tuesday. The U.S. stock market opened lower on Tuesday morning after being closed on Monday for the Labor Day holiday. In early morning trading, the Dow, S&P 500 and Nasdaq were all down 0.30%-0.40%.
Needless to say, we are watching this situation very carefully. The stock market has experienced very little volatility lately, despite a great deal of uncertainty in Washington, including a delay in the implementation of the Trump administration's policy agenda. The market seems to be increasingly taking this uncertainty in stride and has continued to climb higher on the back of strong economic data. But, the one thing that can trigger volatility is the situation with North Korea. If there's one issue certain to get people's attention, it's the threat of nuclear war, which represents an existential threat to humanity. A military strike on North Korea, given the uncertainty of success and the fact that it would likely trigger retaliation – risking an all-out nuclear war – seems highly unlikely; even unthinkable.
Apart from the issue of a potential military strike, the ongoing saber rattling between North Korea and the Trump administration could have an impact on the market given the implications for trade relations between the U.S. and China. On Sunday, President Trump tweeted that he was considering stopping all trade with any country doing business with North Korea. The most significant country doing business with North Korea is China, which accounts for 90% of all trade with the regime. If Trump were to follow through on this threat, that means the U.S. would cease doing business with China, which seems highly unlikely given that China is the U.S.' largest trading partner. Trade between the two nations amounts to $650 billion. Marianne Schneider-Petsinger, a U.S. geoeconomics fellow at Chatham House, a think tank based in London, comments that "Cutting off trade with China would trigger a trade war and a protectionist spiral that would have adverse consequences for the entire world." She adds, "We're talking about a global recession and devastation for the global economy."
Both a military strike and a trade war with China are almost unthinkable. No wonder most analysts say there are no good solutions when it comes to the North Korea problem.
President Trump's threat is likely hyperbole – merely a strategy designed to get China to take an even stronger stand against North Korea. China’s actions so far have been ineffective at stopping the North Korean regime from continuing its bellicose behavior, and Trump seems determined to prod the Chinese to do more. On Monday, Trump announced he had agreed to lift limitations on the payloads of missiles sold to South Korea. He also indicated he was willing to sell billions in arms to South Korea. Meanwhile, the U.S. ambassador to the U.N., Nikki Haley, pushed the U.N. Security Council to impose even tougher sanctions against the North Korean regime.
As the rhetoric heats up, we would expect investors to increasingly shift to a "risk off” stance. We may see a pullback or correction in the stock market, which is long overdue. For our part, we have been expecting volatility to crop up at some point anyway and feel that our portfolios are well-positioned to weather such a storm. In our balanced asset allocation strategies, we recently trimmed our U.S. large cap equity allocation, thereby raising some cash in the process. We view this cash as "dry powder" which we can use to take advantage of any opportunities that might arise with a market pullback or correction. Moreover, our balanced account strategies are diversified, which helps ameliorate the effects of volatility. History has shown that geopolitical-related market corrections tend to be temporary in nature. Unless the response to this recent bomb test results in a military strike, or a halt in trade between China and North Korea that leads to a complete collapse of the North Korean regime – both of which we think are unlikely occurrences – we expect tensions to eventually be defused and any market volatility to be short-lived. In the meantime, rest assured that we will be watching this situation very carefully and adjusting our portfolio positioning as necessary.
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