Don't underestimate the risks from Korea
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Don't underestimate the risks from Korea

  • The crisis on the Korean peninsula could be a catalyst for a significant setback in markets
  • Too many investors can not countenance a serious setback to the value of their savings, significant fund outflows from markets could follow.
  • Investors should check they are not overexposed to risk assets or leverage in their portfolios
  • Maintain healthy weightings in cash, gold and safer bonds

Don't underestimate the degree to which the Korean crisis could act as a catalyst for a significant sell-off of markets even if the situation were to quieten down. Markets are long overdue a significant correction, and quite frankly there are enough structural and cyclical arguments for risk asset prices such as equities to be materially lower.

Throughout history when nations build-up their weaponry they almost feel emboldened to fight someone. North Korea has been building its military spending for some time. It spends a massive 22% of GDP on its military, thought to be the highest in the world relative to the size of the country. Donald Trump’s budget request for 2017 envisaged spending of $639bn a 10% increase year-on-year. Unfortunately, the world also has to face the fact that the country with the largest military spending in the world has one of the world’s least diplomatic leaders. Conducting bellicose dialogue with other global leaders through Twitter is not a strategy to defuse this extremely dangerous geopolitical situation.

The situation could lead to a stand off between the superpowers of the United States, China and possibly Russia. China sees North Korea as an important buffer on its border from the US and its military allies of South Korea and Japan. Premier Xi doesn’t want a crisis as he heads into the People’s Congress later this year. He will be under internal pressure to stand up to any challenges from the US. The crisis could also draw in Russia. Not to be forgotten is that if the US was to gain some control over North Korea, Russia would feel that their important port of Vladivostok would be at risk.

China would prefer that the status quo is maintained where North Korea for all its failings remains an independent country but that it would back down from seeking to have a credible nuclear bomb threat. China fears that were the North Korean regime to fall then China would be facing a serious influx of refugees. Hence China might be considering that should the North Korean regime fall that they may be forced to invade the northern border of North Korea to stop the refugees.

Why this is dangerous for investors

The markets can’t easily classify this crisis and come to any strong conclusions as to how it might play out. The crisis has a nuclear angle; it is not similar to a Middle Eastern conflict as played out in Suez crisis, Kuwait or Iraq. It is potentially nuclear with the only comparison 'the Cuban crisis' in the 1960’s. It was easier to beat up on Cuba in 1962 than it will be to push the North Korean regime back from the brink.

Too many investors just couldn’t wear another serious setback to the value of the wealth. 10-years on from the 2007-2009 world financial crisis, investors are even more risk averse as baby-boomers are 10-years closer to retirement and even more sensitive to investment losses. Even with the recent rise in asset prices, baby boomers are thought to have only half of the necessary savings to see them through their retirement.

Central banks may be impotent to stimulate the global economy in any significant downturn. They may have sufficient tools to bring some order to the financial markets. However, they have limited powers to reinvigorate confidence in the aftermath of whatever form of crisis possibly transpires. Amongst the major central bank's policy interest rates are at zero or barely above. Cutting interest rates will possibly provide very limited stimulus to the global economy.

Governments are already highly indebted and would rather not have to rescue their economies with a ramping up of tax cuts and spending increases. G7 Government debt to GDP has already risen from 50% to 90% over the past decade due to the world financial crisis.

What to do

The hope is that the politicians will resolve the issues on the Korean peninsula and that markets can from the low-end of a recent trading range. However were the Korean situation to develop into a full-blown crisis the sell-off could be violent. I would encourage every investor to just check that they are truly comfortable with their current asset allocation. The bias should be to have a more cautious strategy than normal and maintain higher levels of cash.

  1. Buy more gold

Tactically I encouraged investors to buy gold a few weeks back, and for those who have still to establish a holding, I would pay up even at levels around the $1300. In any case, the arguments in favour of gold have strengthened with the weakness of the dollar and reduced expectations for a further US interest rate rise this year.

2. Ask yourself how you would feel if equities fell 30% to 50%

I would suggest that all investors to check to see that they are not overexposed to risk assets. An enlightened investor would not typically have more than 40-50% portfolio allocation to equities. Such an allocation should at the very least provide a benchmark for anyone to assess his or her own exposure. The low volatility of equity markets in recent years has led to some complacency amongst investors who have seen only seen gains and where buy on the dips has been a successful strategy. The warning sign was the last week’s rise in volatility as measured by the VIX index rising to 15.5% up from 10% a few days ago.

Even assuming that the geopolitical problems quieten down somewhat, and the politicians back off from their worst posturing, the equity market technicals point to downside risk. Bill Sarubbi at Cycles research LLC points out that the S&P500 went from a new high to the largest negative open in more than a month. Such incidences in the past have been followed by lower markets on 11 out of 16 occurrences. 

3. Remember high yield bonds are not government bonds

Government bonds are the low-risk asset. Higher risk bonds hit a three-week low past week however valuations are still rich relative to history. For choice, investors should have higher than normal allocations to bonds. However, investors should ensure they have not skewed their bond holdings to equity like proxies such as high yield (junk) bonds.

4. Hold a good measure of cash to give you options on any setback

Even before the North Korean situation flared up, I was advocating that investors should take profits on the sharp rise in risk asset prices. I would target portfolio cash of 10-15%. Let’s just hope this crisis blows over in which case investors can look to re-enter the market at lower/cheaper levels.

5. Be very careful with the amount of leverage you may have set against your investments

Remember that when you get cautious, and markets sell off the banks who provided you with the leverage tend to get more cautious and margin calls become a significant problem.

…and meanwhile the global economy is just not going to plan

Outside of the geopolitical challenges, the structural problems in the global economy are still very evident. Last week’s worse than expected US inflation report shows that the Federal Reserve is still very challenged to generate inflation at its target of 2%. The July inflation report showed core inflation at just 0.11% month-on-month the fifth month in a row of weak numbers. JPMorgan estimate that the next reading of the core PCE deflator, the Fed’s preferred measure of inflation, will see a fall from 1.5% to 1.36%, well adrift of the Fed’s target of 2.0%.

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