Co-written by Melissa Doscher, Senior Manager, Risk Services
As of November 15, 2017, North Korea has conducted 15 ballistic missile tests in 2017 alone. These tests illustrated a significant pickup in activity from previous years and further developments in the regime’s capabilities, including solid-fuel and intercontinental ballistic missile (ICBM) technology.
The effect of geopolitical tension in the region and beyond
The increased rhetoric and escalating military tension has been met by divergent reactions from world powers.
On Monday, September 25, 2017, Japan’s Prime Minister Shinzo Abe called for a snap election, seeking a new term at the helm of the world’s third-largest economy as tensions with North Korea continued to escalate. A few days later, he dissolved the House of Representatives, a precursor to the general election. These drastic measures, a far cry from Shinzo Abe’s earlier plan to revise the country’s pacifist constitution and move to slowly increase its military preparedness, were mostly supported by voters, who had been influenced by fear after North Korea fired two ballistic missiles over the country and threatened to “sink” Japan. This was confirmed in October, when Shinzo Abe was re-elected after a big election win.
As we discussed in a blog earlier this year, “State of the Markets: The French Election, China, and the Impact of Trump’s First 100 Days on Credit Risk”, Chinese President Xi Jinping’s chance of getting re-elected in the October vote would be greatly benefited by stability in the region. So, it came as no surprise that China called for all sides in the North Korea missile crisis to show restraint and, even though their government has also been angered by the missile tests, they urged allies to dial back their military drills. The country, nevertheless, did reassure the world that it is committed to upholding sanctions against North Korea. Xi Jinping’s strategy worked — China’s ruling Communist Party voted in October to preserve Xi Jinping’s name and ideology in its constitution, elevating him to the level of founder Mao Zedong.
While Xi Jinping is sending an envoy to North Korea following President Trump’s visit during his November Asian tour, it is important to note that 1) the foreign ministry is quick to point out that this meeting is a “common practice” to exchange views on issues of shared interest and is unrelated to Trump’s visit; and 2) they do not support denuclearization, but rather “dual suspension”.
South Korean President, Moon Jae-in, was elected on a relatively dovish platform of peaceful, diplomatic outreach to China and North Korea. However, South Korea’s largest opposition party is calling on the United State to redeploy nuclear weapons to their country. And, in the wake of additional North Korean missile tests, the South Korean President called for a «temporary» deployment of the full defense battery.
Pew Research Center conducted a public opinion poll that suggests that the grand majority of South Koreans have no confidence in President Trump. The White House has assumed a new posture, engaging in an escalating war of words with North Korea leader, Kim Jong Un, while pressing China and Russia to do more to contain the regime’s nuclear developments. At the United Nations’ General Assembly, he called on world leaders to increase pressure on the North Korea regime, particularly China, who he sees as the only substantial diplomatic leverage over the regime. Most recently, President Trump’s escalating rhetoric resulted in him being “sentenced to death” by North Korea for insulting Kim Jong Un.
Similar to China, Russia is urging Washington to ease up on its fiery war of words. In fact, a recent article from the BBC noted that, “Russia’s foreign minister has likened the war of words between Donald Trump and Kim Jong Un to a kindergarten fight between children.” They also warn of the possibility of mass casualties if the aggressive words escalate to military actions and use of nuclear weapons in the region.
Impact on global markets
To examine the impact of this crisis on relevant global markets, we measured the performance of various indices and stocks on the day before and the day after each of North Korea’s missile launches. The analysis focused on the United States, China, Japan, South Korea, and Russia. The Probability of Default Market Signals (PDMS) country benchmarks, which measure the median market-implied corporate credit risk within a country, show that, on average, risk increases for the United States, South Korea, Japan, and Russia when each of these missile tests occur, while it decreases for China, although some market-perceived risk can be seen in that country as well.
Following the March 21, 2017 North Korean missile test, the PDMS model for the U.S. jumped 17% and for Japan 15%. Following the July 28 test, the same measure jumped 20% for South Korea. However, it is interesting to note that the reaction is not always in the direction many people might assume. While the risk increased by 22% and 13% for Japan and South Korea, respectively, after the recent September 3 hydrogen bomb test, it actually decreased by 9% for the United States.
Country- or region-specific S&P Broad Market Indices (BMI) are designed to measure stock market performance in each country or region. Japan and South Korea stock markets are the most sensitive to North Korea’s missile launches. The S&P Japan BMI falls, on average, eight basis points each time North Korea tests a missile and the S&P Russian Federation BMI.
When it comes to individual company stock performance, it is not bad news for everybody. On average, all top five U.S. military contractors have seen their average shares prices increase the day following a North Korean missile test. The two largest Japanese subcontractors, however, have seen their average share prices drop on the same dates. We get a mixed signal from South Korea, where share prices for the largest military subcontractor dropped, but increased for the second largest one. However, we note that the average market-implied credit risk increased for three of the U.S. companies (Raytheon Companies, General Dynamics Corporation, and Northrop Grumman), even though their average share price also increased.
As of November 15, it has been about two months since the last North Korean missile test. Is the country freezing its militarization plans? Not necessarily. While North Korea is still showing its commitment to continue developing its nuclear capabilities, it appears that right now it is taking a small break to focus on economic development and building support for its leadership – even the North Korean media is now dominated by photos of Kim Jong Un riding tractors, laughing with workers, and visiting farms instead of making appearances at missile tests and weapons factories. Officials caution that all of this could change at any time, and, with this change, could come a new wave of impacts on global markets.