The rising risk from North Korea
- and what it means for markets
Chief Analyst
Allan von Mehren
+45 45 12 80 55
[email protected]
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
Chief Analyst, Allan von Mehren, [email protected]
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.
Chief Analyst, Allan von Mehren, [email protected]
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
2009
NK conducts second nuclear
test after Six-Party talks
broke down in December.
New sanctions by UN
2003
NK withdraws from the NPT.
Declares it has nuclear
weapons
1994
NK pledges to freeze and
dismantle old nuclear
reactors
1985
North Korea signs
Nuclear NonProliferation Treaty
(NPT)
2006
NK test fires long range
missiles. UN Security Council
pass resolution demanding
NK suspend the program
2006
In October,
successful test
of first nuclear
weapon
2005
NK agrees to give up
nuclear programme in
exchange for energy
assistance and economic
cooperation
Chief Analyst, Allan von Mehren, [email protected]
2017
US Trump
administration says
era of ‘strategic
patience is over’
2013
NK conduct 3rd nuclear
test (first one under Kim
Jong-Un. UN orders new
sanctions
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
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
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.
13 Feb
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.
6 Mar
North Korea fires four ballistic missiles into the waters of Japan.
6 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.
14 Apr
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.,
15 Apr
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.
16 Apr
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.
Chief Analyst, Allan von Mehren, [email protected]
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.
Chief Analyst, Allan von Mehren, [email protected]
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
Chief Analyst, Allan von Mehren, [email protected]
‘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.
Hopefully, step 1 will be
enough to stop Kim Jong-Un
from doing more nuclear tests
•
Make it clear to allies South Korea and Japan that the
US is 100% behind them.
A new nuclear test by NK
would escalate the situation
•
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.
Chief Analyst, Allan von Mehren, [email protected]
‘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
Chief Analyst, Allan von Mehren, [email protected]
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
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.
o
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.
Chief Analyst, Allan von Mehren, [email protected]
‘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.
80% of North
Korea’s trade
is with China
• 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.
Chief Analyst, Allan von Mehren, [email protected]
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
Chief Analyst, Allan von Mehren, [email protected]
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.
Equity markets not worried so far – an escalation
would hit Asian stocks the most
− 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.
Escalation of the NK crisis would lead to safe haven
flows into fixed income, pushing yields lower
− 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%.
Source: Bloomberg, Danske Bank
Senior Strategist, Christian Tegllund Blaabjerg, [email protected], Chief Analyst Arne Lohmann Rasmussen, [email protected]
14
Military conflicts increase uncertainty
Senior Strategist, Christian Tegllund Blaabjerg, [email protected]
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.
So far little effect on KRW or JPY
− 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.
Metal prices could take a further hit
− 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.
Source: Bloomberg, Danske Bank
Chief Analyst, Christin Kyrme Tuxen, [email protected],, Chief Analyst Jakob Ekhold Christensen, [email protected], Senior Analyst Jens Nærvig Pedersen, [email protected]
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.
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Disclosures
This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S ('Danske Bank'). The author of this presentation is Allan Von Mehren,
Chief Analyst.
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