September 15, 2017 / 1:53 PM / 5 months ago

Have investors grown too comfortable with North Korea?

LONDON (Reuters) - North Korea’s latest missile launch has sparked yet another round of international condemnation but in a pattern increasingly playing out in financial markets, investors already seem to have shrugged it off.

A closer inspection however, reveals this is not unusual: market reactions to bellicosity from the reclusive nation shows stock market drops, spikes in volatility, gold and the Japanese yen - typical “risk-off” moves - often reverse within a few days, sometimes within hours.

The reason? Weapons tests and aggressive rhetoric around the Korean peninsula have never escalated into full-blown conflict, often only culminating in diplomacy and increased sanctions.

“Our sense is that investors have grown comfortable with the view that geopolitical tensions invariably result in diplomatic talks, in which case the right trade is to buy any dips,” writes Goldman Sachs head of global credit strategy Charles Himmelberg.

“The result is a market psychology that is relatively resistant to the pricing of geopolitical risk.”

A Reuters analysis of various “risk-off” moves shows market reactions to tensions in the Korean peninsula have tended not only to reverse more quickly than others, but in most cases register a smaller move compared to those on other risk events.

Here are some graphics that show how different asset classes and market measures - stocks, volatility, gold and the Japanese yen - illustrate this phenomenon.


(Global stocks' resilience in face of risk events:

After the first three North Korean nuclear tests the MSCI World Index recouped its initial losses on the same day. On the fifth and the most recent sixth test, the index posted a positive close just one day after its initial fall. North Korea’s threat to strike the U.S. island of Guam and its fourth nuclear test were the only occasions on which it took longer than a day to recover.

The results of the Brexit vote, the Fukushima nuclear disaster, the collapse of Lehman Brothers and Greece’s 2015 debt default all pushed the MSCI World Index .MIWO00000PUS lower than any of North Korea’s nuclear tests.

(What North Korea means for stock markets:


(Volatility regimes vs. risk events:

A similar pattern plays out in the VIX index .VIX, also known as the market’s “fear gauge”: for the first three nuclear tests by the North, it snapped back to previous levels within two days. The VIX stayed elevated longer in the wake of the 9/11 attacks than North Korea’s latest nuclear test.

The highs the VIX hit on 9/11, the collapse of Lehman Brothers, Brexit, the 2016 U.S. elections, and the 2015 Greek debt default are all higher than the levels seen on four out of the total of six nuclear tests by North Korea.

(Volatility moves on selected risk events:


(Gold reactions on "risk-off" days:

A similar pattern can be seen with gold - a preferred safe-haven bid for investors on “risk-off” days. Brexit, the 9/11 attacks, the 2016 U.S. elections and Lehman Brothers’ bankruptcy have all caused a higher spike in the metal than any of North Korea’s nuclear tests. Spot gold prices XAU= actually declined on the occasion of the first North Korean nuclear test.


(Japanese yen reactions to selected risk events:

Brexit, Fukushima, the U.S. elections, the Lehman collapse and the 9/11 attacks all saw bigger gains for the yen JPY=EBS than on five out of six of North Korea's nuclear tests.

(Yen move duration on selected risk events:

For three out of the North’s six nuclear tests, the yen gave up its “risk-off” gains within two days, and on two of them it gave back gains on the day.

But are investors getting too comfortable with the status quo? Economists at Capital Economics reckon a conflict of even a few months on the Korean peninsula could wreak havoc not just on South Korea’s economy but shave points off global growth too, given that South Korea accounts for 2 percent of global GDP.


(War-time peak-to-trough change in GDP:

“A 50 percent fall in the value of South Korea’s GDP would directly knock 1 percentage point from global GDP,” economists Gareth Leather and Krystal Tan wrote in a note to clients.

They also warn of disruption to global trade flows: “South Korea is heavily integrated into regional and global manufacturing supply-chains, which would be severely disrupted in the event of a major military conflict.”

Reporting by Ritvik Carvalho; Editing by Toby Chopra

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