alarm clock with world map on face

By Kelly Bogdanov

After a multiyear hiatus, geopolitical risks are back on the table amid aggressive rhetoric between North Korea and the U.S. along with related missile tests and fresh economic sanctions.

Factoring this or any credible geopolitical threat into investment decisions can be challenging given the wide range of potential outcomes, some with high stakes.

Add to that, there is an unpredictable, young leader on one side squaring off with an unpredictable, new president on the other side who campaigned on a noninterventionist foreign policy platform but is increasingly making interventionist moves in multiple regions of the world. Then there are the vital interests of South Korea along with the roles of neighboring China, Russia, and Japan.

The North Korea situation comes at a time when equity markets are sitting just beneath all-time highs and the global economy and corporate earnings continue to show signs of buoyancy. In other words, markets have good reasons to look past the geopolitical risks, as long as they don’t escalate to a dangerous level.

We examine how previous geopolitical incidents impacted equities, highlight the proverbial “canaries in the coal mine” related to North Korea, and discuss rules of thumb about factoring geopolitical risks into portfolio decision-making.

The world's 10 largest militaries by active personnel

10 largest militaries by active personnel chart

Source: RBC Capital Markets, RBC Wealth Management, World Bank, OECD

Tension and release

Historically, equity markets have reacted to military clashes in a more muted manner than one may think.

The S&P 500 fell 6.3%, on average, in 17 post-WWII military conflicts listed in the table below. The market’s reaction lasted an average of only 30 days. At times equities weakened during the run-up to the conflict as tensions were mounting, and recovered soon after it began.

But like any small sample size, there were notable deviations. Markets were not immune from volatility and losses. Some events sparked 10%+ corrections and negatively impacted the economy.

For example, the S&P 500 dropped 15% when the U.S. bombed Cambodia during the Vietnam War, and it declined 16% when Iraq invaded Kuwait. The 9/11 terrorist attacks brought about a decline of almost 12%. Each of these events occurred during recessions and likely extended or exacerbated the periods of economic weakness.

S&P 500 responses to select acts of war and terrorism since WWII

S and P 500 responses to acts of war

* Other economic and monetary policy factors negatively influenced the number of days it took the market to get back to even; this is not counted in the average number of trading days back to even. Source: RBC Wealth Management, RBC Global Asset Management, Wikipedia, The National Security Archive at George Washington University, U.S. Naval Institute. Data attempts to capture any pre-event impact.

It may seem surprising the market did not react more sharply to the Cuban Missile Crisis or the Six-Day War Israel faced given their gravity. The lesson seems to be that when military aggression or wars are significant on a geopolitical scale, it does not necessarily mean equity markets will automatically sell off sharply. Numerous circumstances shape market performance at any given time.

In the case of the Cuban Missile Crisis, the S&P 500 had already plunged 26% months ahead of the confrontation. This “flash crash” had far more to do with extremely high equity valuations, the unwinding of market excesses, and trading mechanics than the prevailing geopolitical strains. The drop may have muted the subsequent selloff during the Cuban Missile Crisis. 

It goes without saying that local equity markets could be affected more dramatically by military clashes or a major terrorist attack if the civilian population and infrastructure are seriously impacted.

Stress tests

The canaries in the coal mine of any forthcoming stress on the Korean Peninsula would likely be gold, South Korea’s government bond market, and select currencies.

Gold is typically the go-to safe haven when trouble hits. Bullion bounced 5% when North Korea recently tested longer-range missiles and the related rhetoric escalated. If tensions re-emerge gold would likely benefit, but otherwise faces some near-term headwinds.

South Korea’s bond market is on guard, as the 10-year government yield now trades at a modest yield premium to the comparable U.S. Treasury yield, erasing a long-standing discount. We think the premium would increase if risks of a military conflict flare up again, as South Korea bond yields would likely rise while Treasury yields could fall (and bond prices would do the opposite).

Credit default swap rates are another important risk measure. The cost of insuring five-year South Korea government bonds against default jumped 22% in just three days when the prospect of a North Korea-U.S. military clash increased. By this indicator, the risk of South Korea sovereigns is now nearly equal to that of Chinese government bonds.

Credit default swap (CDS) rates for five-year sovereigns

(in USD basis points)credit default swap rates chart

Source: RBC Wealth Management, Bloomberg; data through 8/25/17

Among currencies, South Korea’s won qualifies as an obvious canary. It declined 2.7% against the dollar during the recent wave of stress. In contrast, the Swiss franc and Japanese yen are often viewed as safe havens. They rose against the dollar when the verbal confrontation intensified.

What’s your comfort level?

More broadly, the North Korea uncertainties raise a pertinent question for equity investors: How should geopolitical risks be factored into portfolio decisions? 

The difficulty in budgeting for geopolitical risks is that they are often unquantifiable and include multiple, complex scenarios that can be outside of the market’s ability to recognize or grasp. Geopolitical events can occur unexpectedly, such as the 9/11 terrorist attacks. At other times, global markets may overreact like they did when Iraq invaded Kuwait. 

In determining equity allocations, investors would be prudent to assume that significant geopolitical risks can crop up from time to time that could push the equity market into a temporary 5%–10% pullback or even a longer-lasting correction of greater magnitude.

If an investor’s current allocation to equities cannot be sustained through these types of declines then there may be a mismatch between the equity weighting and liquidity needs, risk tolerance, or time horizon that should be addressed. Funds earmarked for equities should be long-term allocations given the steep swings the equity market can (and usually does) have.

As geopolitical events play out, the market ultimately gauges the potential economic implications. Indicators such as consumer and business confidence, retail sales, and manufacturing activity, along with commodity prices, tend to be the arbiters of whether a geopolitical event will have a transitory or longer-term impact on markets and economies.

Maintenance check

The North Korean flare-up is a reminder that it’s always the right time for investors to assess whether their equity exposure is appropriate given their full financial profile and if equity allocations are properly calibrated to match one’s liquidity needs, risk tolerance, and time horizon, among other factors.

With or without the escalation of concerns around North Korea our recommendation would argue for leaning against risk by scaling back equity allocations, or sector exposures or individual security positions that may have ballooned during the recent rally. The amplified geopolitical risks underscore this message.


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