Ogre Battle: United States Takes on North Korea … Implications for Stocks

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co

Key Points

  • The S&P 500 was hit with a sharp near-1.5% reversal last Thursday, followed by a relief rally.
  • We don't believe significant military escalation is the likely outcome of the battle of wills between President Trump and North Korea’s Kim Jong Un.
  • But it is a year ending in "7" and there are other forces at work which could keep stocks in a choppy pattern for the next couple of months.

Last week, President Trump promised to unleash "fire and fury" on North Korea, which prompted its leader Kim Jong Un to see that bid and raise it to a direct threat against the U.S. territory of Guam. Collectively at Schwab (Schwab Center for Financial Research as well as our experts in Washington, DC) we believe the likelihood of military action remains low.

The best-case scenario is that the situation remains a battle of wills and rhetoric between the two leaders, without significant military action. The worst-case scenario is significant military escalation leading to all-out war; but as noted, we view that probability as presently low.

Geopolitical experts weigh in

I consume quite a bit of research which is generally less available to the investing public; so it's often the case I like to share important tidbits. Gavekal Research is one such firm, and their world-renowned geopolitical experts recently weighed in with their perspective on the North Korean conflict:

"For both North Korea and U.S.-China trade, the realities are simple to state and the conflicts manageable only by patient diplomacy and compromise. Threats of military or economic force are empty bluster, and recognized as such by their targets."

"The only plausible resolution to the North Korea problem is for the United States to find a face-saving way to accept the existence both of the Kim regime and of its nuclear deterrent, in exchange for a credible program to halt further nuclear arms development. This will require cooperation from China, which has a common interest with the United States in a stable Korean peninsula and a freeze on Pyongyang's nuclear ambitions."

Also worth digesting are the views of the geopolitical experts at Eurasia Group (EG), run by my friend Ian Bremmer (with whom I shared some cheer on Nantucket last week). EG believes the probability is growing that the United States and its Asian allies will adopt a policy of "containment and deterrence" toward North Korea’s nuclear program. This could increase long-term friction in U.S.-China relations, which could mean a more elevated level of market volatility in the near-to-medium term.

EG believes the key variable to watch in the next several months is whether President Trump "looks for narrow wins or takes broad aim at China’s industrial policies focused on technological advancement."

Finally, experts at TS Lombard wrote this in their latest note on North Korea:

"Trump and Kim Jong Un are working themselves into positions from which they cannot retreat, and have left China on one side given Beijing's twin desire for denuclearization and regime preservation. After Trump's 'fire and fury' and 'locked and loaded' rhetoric over the past week, it is hard to see how he could stand by and watch fresh missile tests by the North, especially if they fly further into the Pacific."

"…leaves a shouldering crisis that could flare up further at any time if Kim goes too far or if Trump decides the U.S. patience is exhausted and that unilateral military action is needed whatever the consequences."

Reversal(s) of fortune

The initial effect of the battle of wills between Trump and Kim was a swift reversal in U.S. stocks to the tune of a nearly 1.5% drop last Thursday (having been at all-time highs just prior); with an attendant spike in volatility (see VIX chart below). This was only the fifth time this year that the market was down more than 1%. As you can see in the second chart below, this has been an extraordinarily calm year for stocks relative to every other year since the financial crisis.

Volatility Index

Source: FactSet, as of August 11, 2017.

S and P 500 moves plus or minus 1 percent

Source: Bloomberg. *As of August 11, 2017.

Since 1928 there have only been eight other years when there were fewer than ten 1% moves at this point in the year (and only three when there were fewer than five). In all eight years, the market had positive returns during the remainder of the year, with an average gain of more than 8%.

History's lesson

We can also look back at history in terms of military conflicts, along with other significant historical events, to see the impact on U.S. stocks in the days, weeks and months after. As you can see in the table below, there was typically some weakness in stocks concentrated in the first few months after the event; but a bit more strength thereafter. Of course, there were many other things going on both in economic and market terms during these events; many of which were greater contributors to market weakness than the historical event itself.

S and P 500 performance after significant events

Source: Strategas Research Partners.

North Korea's provocations

Honing in specifically on events involving North Korea, The Wall Street Journal analyzed 80 international incidents involving North Korea and its nuclear program since 1993 and found little connection between tensions on the Korean Peninsula and financial markets. The 36 North Korean nuclear or missile tests detailed by the Arms Control Association were followed on average by a decline of 0.4% for the S&P 500 in the subsequent trading session, with a rally thereafter in the majority of instances.

The historical event being cited most often as a (loose) parallel to the current tensions with North Korea is the Cuban Missile Crisis in 1962. During that period, the S&P 500 did suffer an 11% correction from August to October; but then had a massive 18% rally from there into year-end 1962.

Investor sentiment shaken (but not yet fully stirred)

Aside from the spike in volatility last week, we also saw one in the CBOE Put/Call Ratio (PCR), invented by my first boss/mentor, the late-great Marty Zweig.  The PCR is the ratio of put options to call options and is a technical indicator demonstrating investors' sentiment. As you can see in the chart below, the spike is indicative of heightened investor stress; although not yet to the level seen during 2015.

CBOE Equity Put/Call Ratio

Source: Bloomberg, as of August 11, 2017.

As noted previously, stocks were hit sharply last Thursday; which also represented a swift reversal from what had been all-time highs for the U.S. indexes. In fact, it was one of the nastier reversals of the current bull market. Historically, the market was pretty choppy for the several week period following similar reversals; but the six-month forward returns were significantly better; i.e., no lasting damage.

Less technical in nature are other reasons to expect that this latest period of higher volatility and choppier market action, including the debt ceiling fight to come as well as the Fed’s initiation of the paring of its gargantuan balance sheet. We expect the latter to commence in September, and will look into the Federal Open Market Committee (FOMC) minutes, which will be released this week, for more color around their plans.

Unlucky 7

Finally, it's a year ending in 7. Where is she going with this one, you may be thinking? More attention is being devoted to this phenomenon recently—including in Barron's this past weekend and in The Leuthold Group’s famous "Green Book" for August —given that we are heading into the period in the year when weakness was often most pronounced in those years. Perhaps it's "mystical," as Barron’' opined; or perhaps it ties into the economic or even political cycles; but the pattern is there nonetheless. As you can see in the chart below, nearly every year ending in 7 since the dawn of the Dow Jones Industrial Average has experienced at least a 10% correction … except 1927—when it came close—and this year, so far.

Dow Jones Industrial Average maximum drawdown for years ending in 7

Source: Bloomberg. *As of August 11, 2017.

We are by no means suggesting investors try to trade around this seasonal pattern or the latest tensions between North Korea. We currently have a "neutral" call on U.S. stocks—with a continued bias toward large caps over small caps—which means volatility can be your friend as it relates to rebalancing around longer-term strategic norms. But we are mindful of the angst the next few months could bring.

A relatively new manifestation of heightened geopolitical turmoil was uncovered by Strategas Research Partners after they dove into the 10-Ks of a representative sample of S&P 500 companies. They found that government and political risk is growing in company risk profiles. For example, 63% of companies in their survey cited the government as their highest risk or growing risk since 2008. The number of words companies are dedicating to government risk increased nearly seven-fold from 2005 through 2016, and it’s an increasingly larger portion of corporate risk profiles.

In sum

We remain of the view that these pullbacks—or even a correction—are in the context of an ongoing secular bull market. Important supports continue to be very strong U.S. corporate earnings and revenue growth (along with deregulation); a "Goldilocks" not-too-hot, not-too-cold global economic/inflation environment; and still-ample global liquidity. Ultimately, those are the primary drivers of where stocks are in their cycle. Yes, this bull market will end eventually; but it's unlikely that tensions between North Korea and the United States will be the catalyst for that … barring an escalation into a war.



Important Disclosures

Copyright © Charles Schwab & Co

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