We have talked over the last 2 weeks of a “Goldilocks” economic environment, with broad-based growth but weak inflation. As such, we have speculated that any headwind for markets would be more likely to come from the political sphere than from central bank tightening. Indeed, over the summer, US President Donald Trump and North Korean supreme leader Kim Jong Un have combined to stimulate market sell-offs on a roughly one day per week basis.
Last week, North Korea conducted several exercises in response to US-South Korea military exercises. This culminated on Tuesday in a missile that flew over the Japanese island of Hokkaido (the northernmost of Japan’s main islands). In reply, allied aircraft conducted tests of bunker busting bombs near the North Korean border. Equity markets again sold off briefly, with safe havens rallying (the US 10 year yield touching its lowest level since November 2016 at 2.08% yield), before calm was restored.
Until this point, underlying economic strength has therefore ultimately trumped geo-political squabbling. Over the weekend, however, North Korea appears to have “upped the ante”, claiming to have tested a hydrogen bomb that could be mounted on a ballistic missile. The explosion triggered an earthquake measuring 6.3 on the Richter scale and is estimated to have been 10 times more powerful than anything detonated before. Trump’s first reaction was to tweet “North Korea is a rogue nation which has become a great threat and embarrassment to China, which is trying to help but with little success”. It is expected that the principal retaliation tool will be via further economic sanctions.
Although North Korea might provide the most extreme political tail risk, there are certainly a number of other flashpoints on the market’s radar: