The heated rhetoric between the leaders of the United States and North Korea continues to flow. The associated uncertainty can be unsettling for market participants, particularly during the summer month of August where trading volumes are already light, and such shocks can thus result in wider than normal market swings. But is the U.S. stock market about to wrap up its worst week since Halloween 2016 because investors really have something to worry about, or has the recent escalation of the North Korea conflict done nothing more than provide a reason for stock traders to take profits in what has been a white hot market since late last year?
When it comes to geopolitical risks, I like to rely just as much if not more on what the markets are telling me versus the latest news reports. Clearly, the risks associated with the ongoing sabre-rattling between North Korea and the United States are certainly real and worth monitoring closely. But while the news reports can be unsettling, they are hard to quantify in terms of the specific magnitude of the risks. Capital markets, on the other hand, can help provide more precise metrics in this regard, for it is one thing to be paying attention, but it is another thing altogether when it comes to individuals making actual bets either directly or indirectly associated with particular outcomes.
With this in mind, the following are five market indicators worth monitoring to determine whether the recent conflict between North Korea and the United States will eventually escalate into a full blown conflict with all of its associated collateral damage or if ends up blowing over without incident.
Before going any further, the one indicator that I will not be mentioning below is the U.S. stock market as measured by the S&P 500 Index (SPY) or the Dow (DIA). We commonly hear this referenced as an indicator of how the economy is doing at any given point in time. And, while it was once not that long ago a useful tool in helping to predict where the economy would be roughly nine months into the future, today, thanks to the boundless distortions by global central banks, the U.S. stock market is nothing more than an indicator of how much monetary policy can inflate asset prices and disconnect them from the reality of the underlying economy. In short, not a very useful indicator for much anymore.
With that editorial out of the way, the following are the five market indicators worth watching in monitoring the probability of the outbreak of military conflict with North Korea both heading into the weekend and in the coming weeks.
The Korean Composite Stock Price Index, or KOSPI, is the primary benchmark for stock market performance in South Korea. While the outbreak of a military conflict between North Korea and the United States would certainly have an impact on the U.S. economy and its markets, such an episode could be both completely transformational and potentially catastrophic for South Korea and its economy. As a result, if we are going to see investor money moving in response to a potential military conflict anywhere across capital markets, it should first show up in South Korean (EWY) stocks.
So, what are we seeing today heading into the weekend? While the KOSPI has certainly had a challenging week in falling roughly -3.2%, such a decline could hardly be considered panic selling.
Moreover, it is important to put this weekly decline in context. Yes, a -3.2% decline to 2,319 in Korean stocks is a notable pullback. But this is the same market that was up more than +20% year to date in hitting new all-time highs at 2,453 just a couple of weeks ago in late July. Whether this is a war risk related pullback or simply a blazing hot market finding a reason to take a breather and consolidate a bit remains to be seen. But the KOSPI is not even technically oversold in its recent pullback. Instead, we would need to see the KOSPI fast tracking its way back to the 1900 to 2100 range before we could begin to suggest that the alarm bells for war on the peninsula are being sounded.
In the meantime, the KOSPI has only fallen back to levels that would have represented new all-time highs as recently as late May. In short, the risk signals remain low here.
The Korean Won And The U.S. Dollar
As evidenced from my editorial above, I believe a degree of skepticism is warranted in relying on any stock market index as an indicator of what may be going on at any given point in time. As a result, another confirming indicator worth monitoring is the exchange rate associated with the Korean won. For if it were a situation where the outbreak of war on the Korean peninsula was being perceived as a real threat, presumably capital would be evacuating out of the country in search of safety. But once again, while the currency has weakened relative to the U.S. dollar (UUP) since late July, it remains measurably stronger for the year to date.
But doesn’t comparing the Korean Won to the U.S. dollar lead to distortions in its own right since the U.S. is also directly involved in the potential conflict? Certainly, but the truth remains that during a time of global conflict or potential geopolitical uncertainty, even if it directly involves the U.S., the global safe haven of choice remains the U.S. dollar. Thus, we would also expect to see a strengthening of the U.S. dollar as well if the threat of war was becoming imminent. But the U.S. dollar today remains effectively at its lows dating back to the start of 2015 despite a smallish uptick in the last few days.
Emerging Market Bonds
Another category in which we would expect to see signs of stress starting to emerge would be in emerging market bonds (EMB). In particular, we would expect to see at least some degree of weakness in the PowerShares Emerging Market Sovereign Debt (PCY) ETF, not only because some of the largest bonds in the product are Korean but also because it has heavier weightings to some of the more speculative emerging markets from which suddenly risk averse investors would presumably be seeing to draw back their capital in search of safety.
But once again, not only are emerging market bonds not showing any signs of stress, they are also holding technical support and are within pennies of new all-time highs.
Another category that has been getting a lot of financial media discussion in recent days related to the escalating conflict between North Korea and the United States is the traditional safe havens of gold (GLD) and silver (SLV). And, while both have certainly risen in recent days, it has hardly been a breakout that would be associated with extreme market stress.
For gold (PHYS), it has certainly rallied, but it was already rising prior to the recent escalation in rhetoric over the past few days. And, even with its recent move higher, it is still only trading at the top end of its recent trading channel just below 1,300 an ounce and is still well below its 2016 highs at 1,377 per ounce.
This is even more so true of silver (PSLV), which has risen strongly by more than +7% in recent trading days. But even with this recent burst, it remains locked below downward trending resistance dating back over a year to June 2016.
So, while the precious metals complex has seen a bid in recent days, it is not anything that would be characterized as unusual or symptomatic of quickly escalating geopolitical stress.
The fifth indicator worth watching are the bookmakers themselves. These are the markets where people are making specific bets with their money on selected geopolitical outcomes.
For example, one such odds maker is Paddy Power, which currently makes markets on several issues related to North Korea. This includes the odds that North Korea launches a nuclear missile this year at relatively low odds of 33/1. Moreover, the odds still definitively favor Kim Jong-un remaining North Korea’s supreme leader until sometime after 2031 at 4/7 odds, an outcome that might be put to the test if live military conflict were to break out between the U.S. and North Korea.
In short, even the direct betting markets are currently assigning a low probability to the outbreak of war between the U.S. and North Korea.
The Bottom Line
While investors understandably and rightfully monitor the events associated with the escalating rhetoric between the United States and North Korea, a variety of capital market signals suggest that the probability of an actual conflict erupting remains very low at the present time.
This, of course, could change, which is why it remains worthwhile to monitor selected market indicators such as these to determine whether the news and any reaction we might see in the U.S. stock market is really in response to the news flow related to North Korea or is little more than noise in a U.S. market that is long overdue for some sort of correction after what has been a particularly strong 2017 year to date.
Disclaimer: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Disclosure: I am/we are long PHYS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long selected individual stocks as part of a broadly diversified asset allocation strategy.