The rising risk from North Korea - and what it means for markets Chief Analyst Allan von Mehren +45 45 12 80 55 alvo@danskebank.dk 27 April 2017 Investment Research www.danskebank.com/ci Important disclosures and certifications are contained from page 18 of this report.
Brinkmanship: The ability to get to the verge without getting into the war... If you cannot master it, you inevitably get into a war. If you try to run away from it, if you are scared to go to the brink, you are lost. 1956, John Foster Dulles, Secretary of State during the cold war under US president Dwight Eisenhower
A dangerous game of chicken is going on between the US and North Korea this is a key risk factor for markets this year Key takeaways The key driver driver behind the escalation is North Korea (NK) advancing fast in developing an Intercontinental Ballistic Missile (ICBM) that could reach the US with a nuclear warhead. The new leadership in the US has been clear that they will not allow this to happen and that the era of strategic patience is over. While the US is currently exercising brinkmanship, the bar for military intervention by the US is very high. A preemptive strike runs with a very high risk of a retaliatory response from North Korea on South Korea and/or Japan that could lead to a significant loss of life. Among the targets of retaliation would be the close to 30,000 US troops in South Korea and the South Korean capital Seoul, with a population of 10 million people. Nevertheless, further escalation in the conflict is still likely. A trigger would be another nuclear test by North Korea and/or continued missile tests with a rising success rate. If the US shoots down a North Korean missile, it would also provoke North Korea and increase tensions. First stage in a US plan to stop NK involves: (1) a strong show of force, (2) pressuring China to take a tougher stance on North Korea, (3) further sanctions through the UN and (4) continuing deployment of the THAAD anti-missile system in South Korea. If this is not enough, military intervention cannot be ruled out ultimately. A further escalation of the US-NK crisis will be negative for risk sentiment especially in Asia. It is also negative for commodity prices and the JPY and CNY, while it should be positive for bonds, USD and gold due to safe haven flows. If it comes to a war, the effects could be significant at least for a period of time. 2
North Korea getting closer to ICBM, which could reach the US The crisis with North Korea has intensified during the reign of Kim Jong-Un, as he has accelerated the number of missile tests and nuclear tests. His aim is to get an ICBM with a nuclear warhead that can reach the US. A submarine-launched ballistic missile with a nuclear warhead would also be able to reach the US. The US has been clear that it will not allow this to happen and has stated that the era of strategic patience is over. We have reached the final stage in preparations to test-launch an intercontinental ballistic rocket Kim Jung Un, New Year Speech 1 January 2017 Source (both charts): Bloomberg, CNN, Danske Bank 3
Crisis to escalate further if/when North Korea does nuclear test Apart from an acceleration in missile tests, North Korea has also advanced its nuclear capabilities. NK has advanced its nuclear capabilities Five nuclear tests have been done since 2006 with a significant increase in estimated yield in kilotons of the nuclear bombs during this period. In 2016, North Korea conducted two nuclear tests the latest on 9 September, two months ahead of the US presidential election. Despite many rounds of sanctions imposed by the UN, North Korea has shown no sign of changing course from becoming a nuclear power with long-ranging missiles. To accomplish this, North Korea needs to be able to increase the length of missiles from intermediate to long ranging, and to minituarise the nuclear bomb to a warhead small enough to be attached to a missile. It is unclear how far along North Korea is with this, but there is no doubt that it has gradually increased its capabilities. At some point, it may reach this stage, unless stopped. The main trigger to look out for now is a new North Korean nuclear test. At the latest missile test, the US administration said it wouldn t respond to it but warned of other actions if North Korea proceeded with plans for a nuclear test. There have been signs North Korea is ready for another nuclear test. 4
North Korea s track record with UN is not great Red circle: NK moving against UN 1994 NK pledges to freeze and dismantle old nuclear reactors 2003 NK withdraws from the NPT. Declares it has nuclear weapons 2006 NK test fires long range missiles. UN Security Council pass resolution demanding NK suspend the program 2009 NK conducts second nuclear test after Six-Party talks broke down in December. New sanctions by UN 2013 NK conduct 3rd nuclear test (first one under Kim Jong-Un. UN orders new sanctions 2017 US Trump administration says era of strategic patience is over 1985 North Korea signs Nuclear Non- Proliferation Treaty (NPT) 2006 In October, successful test of first nuclear weapon 2012 NK agrees to moratorium of longrange missile launches and nuclear activity in exchange for aid 2016 NK conducts two nuclear tests (in January and September 2005 NK agrees to give up nuclear programme in exchange for energy assistance and economic cooperation 2007 NK agrees to close main reactor in exchange for aid 5
Crisis heating up between the US and North Korea this year 2017 1 Jan 13 Feb 6 Mar North Korean leader Kim Jong-Un pledges in New Year speech that NK is close to having an Intercontinental Ballistic Missile that can reach the US. North Korea fires ballistic missiles into waters of Japan during a visit by Japan s Prime Minister Shinzo Abe to Donald Trump s Mar-a-Lago. North Korea fires four ballistic missiles into the waters of Japan. 6 Apr 14 Apr 15 Apr 16 Apr North Korea fires ballistic missile ahead of Trump-Xi meeting. The missile fell into the Sea of Japan. It comes after the US, Japan and South Korea finish naval military drills. China warns a storm is about to break on the Korean peninsula after the US supposedly redirected the USS Carl Vinson strike group towards the South Korean waters. The Chinese Foreign Minister said the situation was on a knife edge. On the same day, North Korea s Vice Minister of Foreign Affairs warned that, we ve got a powerful nuclear deterrent already in our hands, and we certainly will not keep our arms crossed in the face of a US pre-emptive strike in a statement to Associated Press. Shortly after, it was reported that the strike group was in fact heading in the opposite direction. However, it has been reported that it could reach the Korean Peninsula by the end of April., North Korea displays several new missiles at a military parade to celebrate the birth of the nations first leader. The new missiles appeared to show new long-range and submarine-based missiles. The US warns of other actions if Pyongyang precedes with nuclear test. North Korea launches another ballistic missile that failed. The Trump administration signals that it would hold back from immediate military or diplomatic response but warned of other actions if Pyongyang proceeds with a nuclear test. There is speculation that the missile test failure was caused by a cyber attack by the US. 6
A preemptive US strike on North Korea not likely at this stage With President Trump s order of a strike on Syria and the huge bomb in Afghanistan, he has shown a more active role in foreign policy than Barack Obama. Hot spot in Asia dots show US military bases It has raised the question of whether he will also be more inclined to make a preemptive strike on North Korea. However, the case with North Korea is very different from Syria and Afghanistan. Any military strike against North Korea comes with a significant risk of retaliation that could be very costly in terms of human lives. A retaliatory strike could hit the South Korean capital Seoul which is home to about 10 million people potentially with a nuclear bomb or nerve gas bombs. The US has 28,500 troops stationed in South Korea that would also be an obvious target for retailiation. NK also has chemical weapons that could be targeted at South Korea and Japan. A step down the war path could lead to a big war where the US would have to go for eliminating the regime and do it fast. If Kim Jong-Un is backed into a corner and believes he will not survive, his actions could become extreme. A US strike also needs to be coordinated with South Korea and Japan as key US allies and targets of NK in case of a war. Source: www.militarybases.com The US is now exercising brinkmanship a term invented by US Secretary of State in 1956, John Foster Dulles. It is a policy where you move to the threshold of confrontation in order to gain an advantageous negotiation position over your opponent. However, it comes with a high risk as the further you move to the brink, the higher the risk of an error that could push you over the brink and bring the situation out of control. The US has put maximum pressure on NK to make it back down from its nuclear ambitions. However, if this does not work, the US may have to go to war or risk losing credibility as suggested by Dulles quote on page one. 7
A war with North Korea would be costly You can get lots of targets North Korea has more than a million men under arms, they've got tunnel complexes, nuclear sites. Could we throw everything but the kitchen sink at it? I guess. But this is also analyzed to death, and when we look at it, we come to the same conclusion every time: We would "win a war," but the price our allies [would pay] far exceeds whatever the gains would be. This is why they call [North] Korea the land of no good options. Jonathan Pollack, Senior Fellow at Brookings Instution, specialize in US strategy in Asia, interview with Vox, 18 April 2017 The situation is extraordinarily complicated and not amenable to either simple solutions or oneoff ad-hoc interventions designed to demonstrate American strength. Hazel Smith, Professor at London s School of Oriental and African Studies, NBC interview 22 April 2017 it should be painfully clear to everyone that there is no military solution to the problem of Kim Jong Un s nuclear weapons. Fraser Cameron, Director EU-Asia Centre, FT letter 4 April 2017 8
How a US plan to stop North Korea might look Step 1: Show strong force of strength by sailing in army fleet to waters close to the Peninsula and warn that it intends to act alone militarily if necessary. Make it clear to allies South Korea and Japan that the US is 100% behind them. Convince China to talk to North Korea and take tougher sanctions on trade against the regime (we estimate 80% of North Korea s trade is with China). In February, China banned imports of coal from North Korea for the rest of the year. Coal is the biggest source of foreign currency for North Korea, accounting for around a third of exports. Step 2: If step 1 fails to stop North Korean missile tests, the US could aim to shoot down NK missiles when tested. If North Korean nuclear tests continue, the US will be in a difficult situation. It could eventually choose a military option in order to not lose credibility. Hopefully, step 1 will be enough to stop Kim Jong-Un from doing more nuclear tests A new nuclear test by NK would escalate the situation Since 1992, the United States and our allies have stood together for a denuclearized Korean Peninsula. We hope to achieve this objective through peaceable means. But all options are on the table. Mike Pence, US Vice President, 17 April 2017 9
North Korea s response to the recent US show of force Nothing will be more foolish if the United States thinks it can deal with us the way it treated Iraq and Libya, miserable victims of its aggression, and Syria, which did not respond immediately even after it was attacked. Spokesman for the general staff of the North s People s Army The United States was becoming more vicious and aggressive under Mr. Trump and that we will go to war if they choose. At a time and at a place where the headquarters deems necessary, it [a nuclear test] will take place. North Korea s vice foreign minister, Han Song-ryol 10
Where does China stand? China is a long-time ally of North Korea s and has had close diplomatic relations historically. Supported North Korea in the Korean War of 1950-53. In 1961, China and NK signed a treaty where China pledged to support NK militarily in case of outside attack. In recent years, the relationship has cooled significantly not least since the current leader Kim Jong-Un came to power in late 2011. China has been against NK becoming a nuclear power and has opposed the nuclear tests by NK. Since 2003, China was a participant in the six-party talks that included NK, the US, Japan, South Korea and Russia. These broke down in 2009. Strategic reasons for China s support for NK: o o From a security standpoint, NK is an important buffer zone to an ally of the US (South Korea). A reunification would lead to a stronger united Korea, likely to be allied with the US with US troops close to the Chinese border. A collapse of NK would lead to a flood of refugees into China. China has appealed for restraint and wants a resumption of sixparty talks. Xi Jinping stressed that China insists on realizing the denuclearization of the Korean Peninsula, sticks to safeguard the peace and stability in the Korean Peninsula, advocates to solve problems through peaceful means, and stands ready to maintain communication and coordination on the Korean Peninsula issue with the US. Statement from China s foreign ministry following phone conversation between Xi and Trump on 12 April 11
China s leverage over North Korea may be overestimated Trump has previously been a strong critic of China, saying China could control North Korea if it wanted. However, after the summit between Xi and Trump in Mar-a-Lago, his tone has softened on this. According to some sources, China has attempted to talk to North Korea in April but North Korea is not answering back. China s Special Representative for Korean Peninsular Affairs, Wu Dawei, visited Pyongyang in February 2016 in order to urge restraint after North Korea announced a plan to put a satellite into orbit with a long-range rocket. Two days after his return to Beijing, NK launched the rocket. Kim Jong-Un has removed people with whom China has had a good relationship among these were Kim Jong-Un s uncle and brother, who were executed and assassinated, respectively. Chinese president Xi Jinping has not yet met North Korean leader Kim Jong-Un during his time as China s president since 2013. China has also backed UN sanctions against North Korea, taking the side of the UN rather than North Korea. China s coal imports from North Korea were banned in February for the rest of the year. At the Xi-Trump meeting, Xi is likely to have agreed to work with the US and squeeze North Korea further economically, in our view. However, China does not believe sanctions alone can solve the issue and wants negotiations back on the table. So far, there is no sign that sanctions are tempering North Korea s military ambitions. They could even reinforce these ambitions if North Korea feels more convinced it will be attacked without nuclear deterrence. 80% of North Korea s trade is with China 12
North Korea s leader Kim Jong-Un how dangerous is he? Kim Jong-Un came to power in 2011 when his father Kim Jong-Il died. His grandfather Kim Il Sung was the supreme leader and founder of North Korea in 1948. Kim Jong-Un has accelerated North Korea s missile and nuclear programme and is determined to make North Korea a nuclear power with missiles able to hit the US with a nuclear warhead. Jong-Un sees a nuclear arsenal as deterring the US from attacking NK, thus securing the survival of the regime (and himself). He has seen Libya s Gaddafi give up a nuclear programme and later end up dead. He has supposedly ordered executions of more than 300 people among these his uncle in 2013 (who was also his mentor) and most likely his brother who was killed in Malaysia in February 2017. It is not clear how mentally fit he is. There are plenty of unconfirmed stories of very brutal executions using heavy weapons, killing a top official for falling asleep during a meeting and others for not being cheerful enough during speeches. This points to a brutal and cynical leader - as many other dictators before him. It is uncertain how dangerous he is but the US seems determined not to take any risks on this matter and not to allow him to develop weapons that could reach the US with a nuclear warhead. 13
Market implications of escalation risk-off in equities and bonds Equity markets: expect the usual risk-off pattern A strong rise in the tensions between North Korea and China/US will most likely lead to a correction in stock markets. The extent will clearly depend on how much it escalates but if it comes to war, look for a big correction as investors are generally long risk assets. Asian stock markets would take the biggest hit. Expect the usual inflows into lower-beta equity markets: DM to outperform EM, US to outperform within DM vs. Europe and Japan. Within Europe expect Denmark and Switzerland to outperform, and in terms of global sector performance defensives are most likely to outperform cyclicals. Bond markets: Safe haven flows to lower yields A clear escalation of the situation into a military conflict is likely to trigger safe-haven flows into global fixed income. Even though the US would probably be a participant in a potential conflict, we would expect the US Treasury market to be the main beneficiary due to its sheer size, and as the market will be able to price out future Fed hikes. We would expect the Fed to go on hold and stand ready to provide support if needed. In Europe mainly core government bond markets including Scandi markets would be likely to benefit. Semi-core and periphery bond markets could come under pressure. Global central banks will stand ready to provide especially USD liquidity in case the functioning of the interbank market is impaired. We could see 10Y Bund yields below zero and 10Y US Treasury yields well below 2.0%. Senior Strategist, Christian Tegllund Blaabjerg, dcbla@danskebank.dk, Chief Analyst Arne Lohmann Rasmussen, arr@danskebank.dk Equity markets not worried so far an escalation would hit Asian stocks the most Escalation of the NK crisis would lead to safe haven flows into fixed income, pushing yields lower Source: Bloomberg, Danske Bank 14
Military conflicts increase uncertainty Senior Strategist, Christian Tegllund Blaabjerg, dcbla@danskebank.dk 15
Market implications of escalation - hit to Asia FX and commodities FX: Don t expect the usual safe-haven moves: A rise in NK tensions should tend to drive safe-haven flows and thus induce a broadbased strengthening of the US dollar sending the USD index higher. But, we stress that EUR/USD is unlikely to decline much given the current status of the euro as a funding currency, and the cross may in fact move higher to the extent that Fed hikes could be postponed. The Scandi currencies should be vulnerable to the associated souring in risk appetite with notably the NOK additionally set to be hit by lower oil prices in this instance. JPY, another traditional safe haven, would likely depreciate vis-avis majors as a NK strike on Japanese territory would be a real risk. CHF is likely to be the only genuine safe haven in this setting. Asian currencies not least the CNY and KRW would weaken in case of a sharp escalation. EM currencies more generally are likely to come under pressure. The most liquid EM currencies like ZAR, TRY, MXN will likely be hit In addition, the currencies of base metal producing countries such as BRL, CLP may take a blow. Commodities: We look for an escalation of the US-North Korean crises to weigh on commodity prices in general due to negative impact on demand from fall in risk sentiment and a stronger USD. The impact will likely be greater in base metals where China consumes half of the world output. However, the price on gold should rise due to increased demand for safe haven assets. So far little effect on KRW or JPY Metal prices could take a further hit Source: Bloomberg, Danske Bank Chief Analyst, Christin Kyrme Tuxen, tux@danskebank.dk,, Chief Analyst Jakob Ekhold Christensen, jack@danskebank.dk, Senior Analyst Jens Nærvig Pedersen, jenpe@danskebank.dk 16
Summary: an escalation is a clear risk watch for nuclear test Key conclusions While the US is currently exercising brinkmanship, the bar for a military intervention by the US is very high. A preemptive strike by the US runs with a very high risk. Nevertheless, a further escalation of the conflict is still likely watch out for another nuclear test by NK. Ultimately, the outcome depends on how the game of chicken between Washington and Pyongyang plays out. The biggest risk is clearly that neither NK or the US backs off and we see a military conflict. A further escalation of the US-NK crisis would be negative for risk sentiment especially in Asia. It is also negative for commodity prices and the JPY and CNY while it should be positive for bonds, USD and gold due to safe haven flows. If it comes to a war, the effects could be significant at least for a period of time. 17
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