The upwards momentum of stock markets has experienced a few pauses this year as a result of the escalating tensions between North Korea and the United States. But so far there has not been a major sell-off. Could that be about to change?
It is beginning to feel as if the US and North Korea are on a collision course leading to inevitable conflict. However, before drawing that conclusion, bear in mind that this has been a pretty consistent and understandable playbook for geopolitical stand-offs. Ultimately, the principal actors tend to respond to the issues in ways which serve their best interests.
The situation here is that both sides are faced with bad options.
North Korea would like to develop a credible nuclear deterrent in order to protect itself against the threat of regime change. The United States wants to avoid a rogue state developing the military capability to threaten US cities with weapons of mass destruction. Neither side wants military action.
North Korea’s trump card is the arsenal of conventional weapons which it currently has targeted at the South Korean capital, Seoul. This threat ought to be strong enough to deter the US from a pre-emptive military strike. But there is also very little incentive for North Korea to launch its own pre-emptive strike as the value of its deterrent would then be lost.
The United States’ power rests in North Korea’s economic reliance on China, particularly for oil. If the US is able to persuade China to tighten sanctions on North Korea then the situation should de-escalate.
The rational interests of both North Korea and the US are to avoid conflict. While we have been given reason to doubt how rational both leaderships might be, the most likely scenario is that military action does not become reality. However, both parties must talk tough as any perceived hesitancy would only serve to weaken their position. North Korea wants the standoff to last long enough for it to become established as a credible nuclear power.
How markets could react to conflict
The threat of military action remains and it might seem logical for it to weigh on financial markets and discourage investors.
But the history of the relationship between markets and conflict is long and well-established. It is best expressed through a quote attributed to the financier Nathan Rothschild in 1810 that investors should “buy on the sound of gunfire and sell on the sound of trumpets” – buy when conflict starts, sell when it ends.
This is one of the least intuitive things about investing. It is about the delicate balance between wanting things to get better but not wanting to be the last buyer of shares. Because it is the act of buying shares that drives their price higher, if you wait until everything is perfect then the only way is down. Hence, in conflict terms, as the trumpet sounds victory the last of the reluctant investors finally buys stocks. At that point the only way for share prices to go is down.
Is this really the case? Perhaps not quite as perfectly as the language suggests but it is certainly true that selling into conflict is generally a bad move. Typically markets will bottom out before a major conflict reaches its crunch point. From the Falklands through to the two Gulf wars, the UK’s involvement in wars has been accompanied by strong equity market performance.
UK stockmarket not hurt by wars
Or consider the period of the Cuban Missile Crisis - the closest the world ever came to nuclear war. During that whole 13 day period of intense geopolitical stress, the US equity market fell just 6% and it was already recovering as tensions intensified going into so-called Black Saturday when East and West stood on the brink of mutually assured destruction.
Even in the Cuban Missile Crisis, US shares fell just 6%
Taking a more drawn out conflict, the Second World War, the same was true. Markets troughed more than two years before the war ended and then more than recovered the losses suffered. Japan was the exception as investors were virtually wiped out but the market still managed to return to profitability eventually - it just took decades rather than the months of the rest of the world.
In the 19th century Nathan Rothschild couldn’t have known the destructive potential of nuclear weapons but as his quote reveals, the history of conflict has offered opportunities for the investment savvy to buy shares from those of a more nervous disposition. It seems likely that this will continue to be the case.
While it may seem dispassionate to be optimising investment strategy at a time of global anxiety, for better or worse markets are like that.
By Guy Foster, Head of Research
Guy leads Brewin Dolphin’s Research team ensuring that a rigorous and exhaustive investment process is employed. He also provides recommendations on tactical investment strategy to Brewin Dolphin’s investment managers and strategic recommendations to the group’s Asset Allocation Committee. Before joining Brewin Dolphin in 2006, Guy was an Investment Director at Hill Martin (Asset Management). Guy has a Masters in Finance from London Business School. He is also a CFA charterholder, holds the CISI Diploma, and is a member of the Society of Business Economists. Guy frequently discusses financial issues with the written and televised media as well as presenting to the staff and clients of Brewin Dolphin.
The opinions expressed in this document are not necessarily the views held throughout Brewin Dolphin Ltd.
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