Equity risk surges as Korean missile crisis escalates


Matthew Peter, Chief Economist

Having reached an historic landmark last week by breaching 22,000 for the first time, the Dow Jones Industrial Average fell sharply on the escalation of the North Korea crisis. Equity markets around the world suffered as the S&P 500, FTSE 100, Euro Stoxx 50, S&P ASX 200 and the Hang Seng all fell by between 1.0% and 1.5%.

In addition, equity market volatility spiked higher, with the VIX index of volatility rising from a level of around 10 to 16. This represents a significant jump from its average over the last four months of just over 10; a sustained period of extremely low levels of the VIX, last seen during the period of the Great Moderation between the dot.com crisis of 2000/01 and the GFC starting in 2007. The catalyst for the drop in global equities and the spike in expected volatility was the escalation of the North Korea missile crisis, as President Trump upped the ante of his rhetoric against Pyongyang. This followed Pyongyang’s threat to launch a nuclear strike against Guam, which in turn followed a threat by President Trump to rein “fire and fury” down on the North Koreans.
 

Despite the sell-off in equity markets and the large jump in the VIX, we have seen similar instances of spikes in volatility over recent months including April, in the lead up to the French Presidential elections and May during the sacking of FBI boss James Comey. Hence, even though the equity markets have recently traversed a period of historically low volatility, it has also been punctuated by intermittent spikes in volatility.

So how worried should we be about current developments? Is the recent cause of the spike in equity market risk destined to fade, as did recent spikes?

Of course, the obvious difference between the Korean crisis and the French elections and Comey crises, and other more recent geo-political risks, is the involvement of credible nuclear war and the possibility of strikes on US territories (such as Guam) or even the US mainland itself. However, even in the absence of a successful attack on US mainland or territory soil, should we consider the Korean crisis in a different light to other recent geo-political crises such as the Syrian/Middle East and Ukraine/Russian crises?

Our view to this question is a clear yes. The key reason is that the knock-on effects of further escalation of the crisis in Korea are far greater than those that could arise from the Middle East or Ukraine.

The problem with Korea is the size of the of the countries and their economies that are being pulled into the Korean crisis. If we consider the sizes of the economies of the countries that would be directly disrupted by a major escalation of the Korean crisis, we find that China, South Korea, Japan, Taiwan and Hong Kong command over 25% of the global economy. In contrast, the Middle East & North African countries account for less than 7% of the global economy. Similarly, within financial markets the potential for disruption in Korea dwarfs that of the Middle East. China, South Korea, Japan, Taiwan and Hong Kong account for 15% of the MSCI All Country World Index, while the shares of the Middle East & North Africa sum to a mere 0.3%.

Added to this is the declining importance of Middle Eastern oil to the global economy as rising efficiency in the use of oil in the production process and the increase global supply of oil emanating from US shale production diminishes the impact of the Middle East on the market. However, it is precisely the threat and outbreak of war in the Middle East that has been the predominant global geo-political threat in the post-Cold War era.

The Middle Eastern threat certainly pales into significance compared to the geo-political threat posed by the Cold War, so it is unsurprising that market volatility has been at historically low levels since the fall of the Iron Curtain. It is also unsurprising that spikes in risk since the end of the Cold War have been dominated by financial crisis such as the bursting of the equity bubble in 2000/01 and the GFC of 2007/09.

Since the Cold War, investors have become conditioned to the ability of global central bankers to contain the risks associated with financial market crises. However, as we enter a period where geo-political risks reassert themselves as the major source of financial market risk, who can play the stabilising role that the central banks played during financial crises? President Trump?

Table 1: Financial market movements, 03 - 10 August 2017

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,438.2

-1.4%

US

2.20%

-2.4 bps

US Dollar Index (DXY)

93.40

0.6%

Nikkei 225

19,729.7

-1.5%

Japan

0.06%

-0.6 bps

USD-JPY

109.20

-0.8%

FTSE 100

7,389.9

-1.1%

UK

1.08%

-6.7 bps

GBP-USD

1.298

-1.2%

DAX

12,014.3

-1.2%

Germany

0.42%

-3.8 bps

EUR-USD

1.177

-0.8%

S&P/ASX 200

5,760.9

0.5%

Australia

2.66%

-0.5 bps

AUD-USD

0.788

-0.9%


Source: Bloomberg

Economic Update


United States

Labour market continues to tighten in the US, with wages ticking up 
  • July’s employment report was strong, with non-farm payrolls rising by 209,000 (higher than the market forecast of 183,000), while June’s gain was revised upwards to 231,000. In addition, the unemployment rate was 4.3%, down from 4.4% in July, and the participation rate ticked up higher to 62.9%, up from 62.8% in June. Meanwhile, average wage growth also improved over the month, rising by 0.3%, up from the 0.2% growth the month prior. 

Weekly Economic Brief

Weekly Economic Brief


Euro area / United Kingdom

Industrial output in the UK recovers over June
  • Industrial output in the UK rose by 0.5% over the month of June, up from the flat result in May. While this is the best monthly gain in 2017, this was driven by a rise in mining activity (i.e. oil & gas) over the month, with manufacturing activity remaining flat.   


China / Japan

Chinese trade data falls short of market expectations over the month
  • China’s trade recovery continued in July, albeit at a slower rate than the month prior, as year-ended growth in imports and exports both fell short of investor expectations. Exports were 7.2% higher than a year earlier in US dollar terms, down from 11.3% in June. Meanwhile, year-ended imports rose 11.0% in July, down from 17.2% growth in June, suggesting a slowdown in domestic demand. As a result, China’s trade surplus in US dollar terms rose to $46.7b in July, up from $42.8b the month prior.
  • China’s year-ended CPI inflation came in slightly weaker than expected in July at 1.4%, down from 1.5% in June. Meanwhile, PPI inflation remained unchanged at 5.5% over July.
  • In Japan, core machinery orders (an indicator of planned capital spending), again surprised on the downside, falling by 1.9% in June (well below the market forecast of 3.7% growth) after a decline of 3.6% in May.

Weekly Economic Brief

Weekly Economic Brief

Australia / New Zealand

Australian business and consumer confidence continue to diverge
  • Total dwelling commitments rose by 0.5% over June, down from 1.1% in May. However, relative to the corresponding month of the previous year, the number of commitments declined by 4% and has been trending downward since February. Owner occupied housing excluding refinancing continued its upward trend, rising by 1.4% in June, marginally down from 1.5% in May. Most notably, investor housing commitments rebounded over the month, up 1.6% following two consecutive months in decline.
  • Business sentiment continued its upward trend since last year according to the NAB Monthly Business Survey, with the confidence index rising to 12 in July, up from 8 in June. Meanwhile, business conditions also improved with the index rising to 15, up from 14 in June. This is the highest level that business conditions have reached since early 2008.
  • Consumer sentiment deteriorated over August, with the Westpac/Melbourne Institute consumer sentiment index declining from 96.6 in July to 95.4 in August. The fall in consumer confidence was due to a deteriorating assessment of family finances, which dropped to their lowest level since the aftermath of Joe Hockey’s first budget in 2014.

Weekly Economic Brief

Weekly Economic Brief

Source: Thomson Reuters, ABS.


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