Summer markets have been roiled as tensions between North Korea and US over the former’s missile-testing programme and designs on nuclear weapons threatened to lead to open conflict.
In one of his first major diplomatic tests, US president Donald Trump railed against North Korea missile testing, threatening “fire and fury like the world has never seen” should the country make further threats.
North Korea has been a target for Trump’s ire both during the presidential campaign and since being elected. He has regularly upbraided Chinese authorities for failing to rein-in North Korea and its ongoing nuclear weapons programme.
The most recent escalation has come amid continued testing of intercontinental ballistic missiles that have the potential to reach the US mainland.
A new round of UN sanctions were recently imposed on North Korea, while strong warnings from Trump were met by threats to fire missiles near the US territory of Guam in the Pacific Ocean.
The dispute has also had implications for financial markets, with several asset classes reacting to the increased likelihood of a potential conflict between the two nations.
Oliver Jones, assistant economist at consultancy Capital Economics, said: “The recent escalation of tensions between the US and North Korea has weighed on the S&P 500.
“But provided that war is avoided, we doubt that this marks the start of a sustained downturn in the index.”
Performance of S&P 500 vs MSCI World over 1mth
Source: FE Analytics
Jones said in other instances when the US has been on the brink of war, there has been little lasting effect on the S&P 500.
He added: “Our assumption is that there will not be a war between the US and North Korea. We are therefore sticking to our forecast for the S&P 500 to end this year and next only a touch below its current level.”
One of the most visible signs of the impact for investors was a spike in volatility.
The CBOE Volatility index – the VIX or so-called ’fear index’, a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices – spiked as the war of words between Trump and North Korean authorities intensified.
The VIX reached above 16, the highest level since the election of Trump as president in November last year, as the below chart shows.
Performance of VIX over 1yr
Source: CBOE
Neil Wilson, senior market analyst at ETX Capital, said: “It’s about time the market woke up – nothing like the prospect of a nuclear stand-off to sharpen mind of investors who had become a tad complacent.”
CBOE Holdings, owner of the Chicago Board Options Exchange, noted that trading volume in options and futures on the VIX had reached all-time highs on 10 August, after North Korea’s threats of a missile strike near Guam.
Several industry commentators have highlighted the low levels that the VIX has been trading at more recently, suggesting that investors had become too complacent about markets.
Richard Turnill, global chief investment strategist at asset manager BlackRock, noted recently that low equity market volatility can last for years “even with sporadic bursts”, noting that it tends to overlap with sustained economic expansion.
He noted: “Low vol by itself does not equate to complacency, in our view. The key question is whether it spurs build-ups of systemic vulnerabilities.
“We do not see systemic risk as high but are on watch for any stealth leverage build-up.”
As well as a spike in the VIX, gold also rose as investors sought greater exposure to safe haven assets.
Ned Naylor Leyland, manager of the $200.9m Old Mutual Gold & Silver fund, said precious metals had jumped as each side responded to the other’s threats.
He said: “While the two monetary metals continue to trade mostly on real yield dynamics, some investors reacted to the escalating tension by buying these traditional safe-haven instruments.
“In the event that war should break out, and that leads to an acceptance of further loose monetary and fiscal policy in the US, we would expect a falling US dollar real yield environment, giving renewed, and sustainable, impetus to monetary metals prices.”
Performance of Bloomberg Gold Sub over 1mth
Source: FE Analytics
Earlier in the month the World Gold Council had announced that demand for the yellow metal had slowed during the first half of the year compared with the prior-year period which experienced record ETF flows. However, this could now be changing.
“Institutional investors appear to be, once again, considering an allocation to gold. Current institutional allocations are at their lowest, relative to historic levels,” said Naylor Leyland.
“Should they start re-allocating, we believe a big move in global gold prices will inevitably ensue.”
He added: “Gold, of course, is already a core asset class for central banks, the super-rich and what are classified as ‘the global poor’.
“Should the North Korea situation develop it may just prove to be the catalyst to push the institutional world to commit flows back to this asset class on a sustained basis.”
However, such measures of fear as a spike in the VIX and a rush to safe haven assets may be overdone, given the low prospect of a lasting impact on markets.
“If the rhetoric looks like it might lead to something, then we would expect some shifting of allocations in portfolios,” said Nick Melhuish, head of global equities at Amundi.
“But overall, we don’t think long only investors will pay too much attention in the short term with the focus being more from shorter term traders.
He added: “Any really large sell-off in Korean or regional risk assets would be perceived as a buying opportunity but we are a long way from that point with a muted market response so far.
“It would be beneficial generally to see this escalating problem resolved and China will be key to this. It will be important to wait for China’s reaction the latest developments.”
Melhuish continued: “The main concern here would be that this acts a negative catalyst for US equities.
“It could converge for example with the Russian probe and lead to a bout of risk-off market behaviour. Equities as a whole would be impacted by this, and it isn’t necessarily the case that Asian markets would be the most impacted.”
Tom Becket, chief investment officer at Psigma Investment Management, said it is very difficult to position portfolios for a geopolitical incident, but much easier to take a view on valuations and future returns.
He said the firm’s portfolios have become increasingly diversified this year, as it has moved away from on-risk positions it employed in 2016.
“Last year was a wonderful time for investors, as many assets were extremely cheap and most were at least ‘decent’ value,” he said.
“As markets have enjoyed a steady progression over the recent past, many of the opportunities have become less attractive and this has led to us progressively reducing risk and a range of profit-taking endeavours.
“Sentiment has become too complacent in our opinion and many investment valuations have become too expensive for us as contrarian investors.
“These steps have meant that our portfolios are broadly balanced, increasingly cautious and highly diversified.”
Becket added: “We have also ensured that we have a total focus on liquid investments so that if we need to move quickly then we can do.
“Given our views that the global economy and corporate profitability do not currently pose major threats and should continue to grow modestly, we would like the opportunity to put some of our cash allocations back to work, although we are not at that point yet.
“However, as always, we will keep an open mind and continue to assess when such a time has arrived.”