Paul Christopher, CFA, is the Head Global Market Strategist for Wells Fargo Investment Institute.

Key takeaways:

  • The market reaction was muted, as North Korea’s latest missile test overflew Japan’s northern Hokkaido Island before landing in the Pacific Ocean.
  • The perspectives from Wells Fargo Investment Institute’s research trip to South Korea, Japan, and China indicate additional market volatility potentially from a variety of sources.

What it may mean for investors:

  • Given that the potential risks cover a wide range of potential outcomes, investors may want to consider pursuing a broadly diversified portfolio as potentially the best balance between the unknowable outcome and investment trends that we see.

I’m writing this aboard a 747 parked at an airport gate in Seoul, South Korea. Our research team has just finished a two-week investment research tour of South Korea, Japan, and China. We spoke with economists, investment analysts, government officials, and a former South Korean diplomat. One main goal of the trip was to learn about the attitudes and estimates of the North Korean risk to Asia and to global financial markets. Before they close our plane’s boarding door, here is a quick summary of what we learned, followed by insights for investors who may be wondering how to proceed, in light of the North Korea issue.

1. A widely held view among those we interviewed is that North Korea’s most likely immediate purpose is to establish a credible nuclear threat as quickly as possible in order to bring the U.S. to negotiations.

Observers in South Korea noted that North Korea’s economy is weak and much of its military technology dates from back to the 1940s. The views we heard emphasized that North Korea fears for its survival and feels threatened by the U.S. troop presence in South Korea. Another broad conclusion was that the North Korean leadership wants to use the nuclear threat as leverage to bring the U.S. to negotiate a peace treaty (and thereafter withdraw U.S. forces from South Korea).

2. Many analysts we interviewed believe that North Korea has nearly finished its nuclear weapons testing.

The consensus among the analysts and political experts we interviewed—some with extensive experience in government and diplomacy in the region—is that North Korea is well beyond halfway through its testing. However, at a minimum, some clear steps remain: The ballistic missile tests have not yet demonstrated an ability to re-enter the earth’s atmosphere. Also, while North Korea’s September 3 nuclear test was much more powerful than previous tests, it is not clear yet that the North Koreans have developed a hydrogen bomb, as Pyongyang claims. The capability to miniaturize and fit a nuclear bomb into a missile is another step entirely.

3. Another widely held view among those with whom we met is that a new war on the Korean Peninsula seems very unlikely at this time.

A more careful review of the perspectives of North Korea’s neighbors reveals a set of regionally-focused angles on the conclusion that war is unlikely at this time. China, for its part, prefers a Communist regime on its border. Yet, China also probably regards North Korea as a threat to Beijing’s goal of regional stability. Chinese leaders maintain a carefully balanced approach, supplying North Korea with energy and key supplies but holding North Korean leaders at arm’s length (North Korea’s leader, Kim Jong Un, still has not been invited formally to China, six years after taking control.) We believe China does not want a war and could intervene quickly to discourage an invasion or an internal coup (as discussed in The Wall Street Journal’s July 25 article, China Prepares for a Crisis Along North Korea border).

The South Koreans showed no heightened fear during our visit. Tourism is reduced somewhat, but the Seoul shopping malls were full and the street traffic seemed even more congested than on our previous visits. One former South Korean diplomat noted that a greater fear in South Korea is that a U.S.-North Korean peace treaty would remove the U.S. military presence from the South’s border with the North.

The South Koreans we spoke with said they did not worry about a nuclear attack, and they widely dismissed a pre-emptive U.S. attack on North Korea. We heard the same in China and in Japan, mainly because they perceive a low potential reward with a high risk. North Korea’s nuclear facilities are likely to be widely dispersed and may not all be susceptible to a U.S. air attack. Yet, the potential devastation from North Korean retaliation remains a high risk. South Korean analysts estimated that approximately 200,000 U.S. citizens and possibly as many as 25,000 U.S. military personnel live in South Korea. Hundreds of thousands of Chinese and Japanese citizens also live in and around Seoul. All would be in the direct path of any North Korean retaliation for a U.S. attack as, of course, would be the roughly 25 million South Koreans living in and around Seoul, which is a mere 35 miles from the border with the North.

4. There is still room for considerable uncertainty and financial market volatility.

Sanctions have not impressed financial markets so far, but sanctions have degrees. The recent pattern of missile tests and more sanctions, until now, has brought short-lived market reactions. Markets may recognize that North Korea can deflect most of the pain of sanctions to its population, as it continues with its nuclear weapon testing. Another level of sanctions could apply to Chinese firms. The U.S. might use this leverage to encourage more Chinese economic pressure against North Korea. However, such U.S. pressure could reduce Sino-U.S. trade, which could dent global economic growth and disrupt financial markets.

Other U.S. responses could fuel greater investor concern. If Washington wants to apply military pressure without attacking North Korea, Japan and South Korea could accept U.S. short- or medium- range nuclear weapon deployments as a deterrent. Alternatively, the U.S. could attempt to intercept a future North Korean missile test. An interception attempt probably alters the negotiating leverage between Pyongyang and Washington, whether the attempt succeeds or fails, and this scenario could have a deeper impact on global markets.

Indecision among friends can be costly. It’s likely that we’ll see uncertainty and market variability while the U.S. and its allies disagree over a clear strategy. South Korea prefers negotiation while Japan sides with the U.S. for a tougher stance. South Korean public opinion has shifted since the missile shots began last summer—polls now show that the public favors accepting U.S. interceptor missiles, as reported in The Washington Post on September 7. Ultimately, the allies must decide whether to tolerate a nuclear-armed North Korea.

Taking a global approach to hedging risk posed by North Korea

Investors may understandably want to protect their portfolios against the risks that North Korea poses. And the perspectives from our research trip indicate the potential for additional market volatility. Still, the risks cover a wide range of potential outcomes. Therefore, a broadly diversified portfolio may potentially be the best hedge against an unknowable outcome. Global diversification does not prevent losses, but it may blunt the risk from a particular scenario. Specifically:

  • Stay with the investment plan: Reallocating a portfolio to address a particular risk may be expensive and undermine a long-term investment plan. There is rarely only one risky political scenario in the world, and experience shows that it has been 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 markets: Rather than trying to foresee the timing and impact of a particular and obscure scenario that may not occur, investors may want to diversify more generally with broad, global exposures. This can potentially include many of the asset classes that historically have had positive returns, during periods of global risk aversion. Even if a war were to develop, investors may want to build a broad diversification to dollar and non-dollar assets, real and financial assets, and U.S. and international assets.

Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses

WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.  Certain opinions represent WFII’s opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. WFII does not undertake to advise you of any change in its opinions or the information contained in this report.  The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities.

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