In spite of appearances, markets don’t really care about the Korean peninsula
‘Markets are much more sensitive to financial and economic policy-related risks – the pace of monetary tightening in the US and the threat of severe tensions in the euro zone’
Following several months of remarkable calm, fear is creeping back into global financial markets.
While there is no sense of panic, a confluence of factors has conspired to unsettle international investors.
The most conspicuous one is the renewed escalation in geopolitical risk, centred around the Korean peninsula but by no means confined to the tense standoff between Washington and Pyongyang. Other flashpoints include the deepening crisis in the Syrian civil war, which prompted US military strikes against the Russia-backed regime of President Bashar al-Assad, and an intensification of the US government’s fight against the terrorist group Islamic State.
The mounting tensions on the Korean peninsula – a show of force by Pyongyang over the weekend began with the showcasing of what appeared to be new intercontinental ballistic missiles and was quickly followed by the firing of a missile which exploded almost immediately after launch – pose the biggest threat to investor sentiment, given the erratic and unpredictable behaviour of North Korea’s young leader Kim Jong-un. The stakes, moreover, are huge, not just for Asia-Pacific but, more importantly, for the pivotal relationship between the US and China.
By the end of last week, geopolitical turmoil was beginning to take its toll on markets.
The Vix index, Wall Street’s “fear gauge” that measures the implied volatility of US equities over the next month, shot up 23 per cent last week to 15.9 points, its highest level since the day after the upset victory of Donald Trump in the US presidential election. The benchmark S&P 500 Index, meanwhile, fell a further 1.1 per cent, marking its third weekly drop in the last four weeks.
Investors have been rushing into so-called “haven” assets. The yield on 10-year US Treasury bonds fell a further 15 basis points last week to 2.23 per cent, its lowest level since the days following the US election. The Japanese yen, a haven currency, has strengthened an additional 2.5 per cent this month to its strongest level against the US dollar since mid-November, putting further strain on the exporter-heavy Nikkei-225 Index, Japan’s main stock market index.
Other closely watched gauges of volatility are also rising.
According to Bloomberg, the Credit Suisse Fear Barometer, which measures the cost of buying protection against a sharp decline in the S&P 500, has surged close to the record high it struck in the weeks prior to Britain’s decision last June to vote to leave the European Union.
Make no mistake, market sentiment has taken a severe knock over the past month or so. But is geopolitical risk the main source of the current unease? And how sensitive are investors to these risks?
What is clear is that the deterioration in market conditions precedes the escalation in tensions over Syria and North Korea. This is not a geopolitics-induced sell-off, but one that is simply being exacerbated by regional risks.
The main culprit for the jitters in markets is Trump.
The trigger for the decline in equity markets and the renewed surge in volatility was waning confidence in Trump’s ability to win Congressional approval for his pro-business policies, brought into sharp relief by his administration’s failure on March 24 to rally support for its health-care plan. As Convergex, a US brokerage, noted in a report last week: “Trump trade 1.0 is over. Markets are growing impatient for those pro-growth policies to actually heave into view”.
Trump is also fuelling volatility in foreign exchange markets. In an interview to The Wall Street Journal published last Wednesday, Trump said the dollar was “getting too strong” and that he would prefer the Federal Reserve to keep interest rates at low levels.
Meanwhile, in Europe, there is mounting concern about the outcome of the French presidential election – the first round of voting is on Sunday – as the gap in the opinion polls between the main centrist and populist candidates has shrunk to just four percentage points, fuelling volatility in the euro.
This shows that markets are much more sensitive to financial and economic policy-related risks – the pace of monetary tightening in the US and the threat of severe tensions in the euro zone are uppermost in investors’ minds right now – as opposed to geopolitical ones, which are far more difficult to quantify. Asset prices, moreover, are still being heavily distorted by ultra-loose monetary policies, particularly in Europe and Japan.
This does not mean that geopolitical risks should be downplayed. It simply means that investors do not know how to price them and are betting that they will recede, as they invariably do.
Still, this does not make the escalating crisis on the Korean peninsula any less worrying.
Nicholas Spiro is a partner at Lauressa Advisory