Paul Christopher, CFA®
Head Global Market Strategist

Key Takeaways

  • North Korea fired an unidentified ballistic missile over Japan in the early hours of Tuesday morning, causing no deaths or damage in Japan.
  • Risk aversion quickly guided equity markets lower but led markets higher in perceived safe havens, such as gold, fixed income, and some currencies.

What it May Mean for Investors

  • While aspects of this missile test are concerning, the factors we continue to monitor give no reason for investors to abandon their diversified investment plans.

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Q: What happened on Tuesday?

North Korea fired an unidentified ballistic missile over Japan in the early hours of Tuesday morning. The missile flew over northern Japan and landed in the Pacific Ocean about 745 miles off the Japanese coast. No damage was reported, and the Japanese did not try to shoot it down. President Trump and Japanese prime minister Shinzo Abe agreed by telephone to add pressure to North Korea, including a call for new United Nations Security Council sanctions.

Q: Why was this missile test a particular concern?

North Korea fired missiles through Japanese airspace in 1998 and 2009—and a satellite overflew Japan in December 2012. The immediate market reaction to this week’s overflight was deeper, because the missile was larger. However, there is no evidence at this point that North Korea was targeting Japan. The missile reportedly broke into three pieces, indicating that it could have been an inter-continental ballistic missile test that simply failed after flying over Japan. 

Another reason for concern is that the U.S. and North Korea have been assumed to be in a dialogue behind closed doors. Firing a missile over Japan makes diplomacy more difficult. Also, the latest test implies that markets cannot necessarily count on dialogue to prevent missile tests.

Q: What was the immediate market reaction?

The missile firing was a surprise, but other potential factors already were weighing on risk appetite. Asian equity markets were lower, led by South Korea’s KOSPI, which fell intraday by more than 1.5 percent. Gold stretched its rally above $1,300 per ounce In currencies, the Australian dollar and Korean won depreciated against the U.S. dollar, while the yen and Swiss franc appreciated. Bond yields fell, although the 10-year U.S. Treasury yield was already below a recent support level of 2.20 percent as of August 25, possibly reflecting concerns about Hurricane Harvey and worries about upcoming congressional debt ceiling negotiations. Gasoline was also higher, as markets dealt with the impact of Hurricane Harvey along the Texas and Louisiana coasts.

Q: What should investors watch for next?

Absent a retaliatory threat from the U.S., markets may respond negatively to the test in the near term but then rebound on new signs of North Korean restraint, or on evidence of diplomatic outreach.  We recommend that investors consider the following:

  1. Watch the U.S. response. Every U.S. administration develops its own approach, and it may take time to accurately predict how this new administration may respond. 
  2. The pace of North Korean technology matters.  North Korean technological capability is accelerating, so any visible development could trigger additional investor selling.
  3. China is key. So far, China has balanced punishing Pyongyang and maintaining the regime. Specifically, Beijing has warned the U.S. and its allies against preemptive attacks against North Korea but also has begun implementing the U.N.’s August 5 sanctions (for example, China has banned North Korean entities or individuals from establishing joint ventures or foreign-owned companies in China as of August 25. Beijing also prohibits existing North Korean companies in China from increasing equity issuance or from expanding businesses—and will restrict Chinese companies from establishing or expanding business in North Korea.).

Q: What perspective should investors take?

It is important to remember that North Korea has been testing (and threatening testing) missile launches for many years. The fact that the tests have not triggered significant military retaliation in the past suggests a deeper logic. After all, the U.S., Japan and South Korea previously have responded to North Korean weapons tests with negotiations that give Pyongyang much-needed food and money, which has helped to slow North Korea’s efforts to develop weapons in the past. After a pause of varying lengths, the testing has resumed. We are not suggesting that the future always will be like the past. However, we see evidence that China and the U.S. are cooperating and that diplomacy can advance—so far.  

Other worries also matter at the moment, including the damage estimates and energy-sector impact of Hurricane Harvey, as well about whether congressional debt-ceiling negotiation may produce a political impasse and trigger another U.S. credit downgrade. These events carry varying degrees of risk aversion—that historically has been positive for bond prices but negative for equities. Also, there is the recent U.S. dollar depreciation, which was aggravated by last week’s market interpretation that the Federal Reserve and the European Central Bank were content with the dollar’s recent losses versus the euro.

Q: What should investors do?

Continue to follow their investment plans: Reallocating a portfolio to address a particular risk can be expensive and undermine a long-term investment plan. There is rarely only one risky political scenario, and experience shows that it is best to focus on concrete steps to help reduce a portfolio’s vulnerability to political risks of any type and timing.

Avoid trying to time the markets: Rather than trying to foresee the timing and impact of a particular and obscure scenario that may not occur, we recommend that investors consider seeking to protect assets more generally with a broad, global diversification—one that includes many of the asset classes that historically have had positive returns during periods of global risk aversion, including bonds, commodities (including gold), multiple currency exposures, and investment in equities of local companies whose domestic orientation may insulate them better from international political upheaval.

Investors cannot be fully immune to particular political events. Instead, diversification is a response to the difficulty of systematically and regularly predicting the reactions of particular markets to particular political events.