A dangerous game of chicken is going on between the US and North Korea – this is a key risk factor for markets this year
The key driver driver behind the escalation is North Korea (NK) advancing fast in developing an Intercontinental Ballistic Missile (ICBM) that could reach the US with a nuclear warhead. The new leadership in the US has been clear that they will not allow this to happen and that the ‘era of strategic patience’ is over.
While the US is currently exercising brinkmanship, the bar for military intervention by the US is very high. A preemptive strike runs with a very high risk of a retaliatory response from North Korea on South Korea and/or Japan that could lead to a significant loss of life. Among the targets of retaliation would be the close to 30,000 US troops in South Korea and the South Korean capital Seoul, with a population of 10 million people.
Nevertheless, further escalation in the conflict is still likely. A trigger would be another nuclear test by North Korea and/or continued missile tests with a rising success rate. If the US shoots down a North Korean missile, it would also provoke North Korea and increase tensions.
First stage in a US plan to stop NK involves: (1) a strong show of force, (2) pressuring China to take a tougher stance on North Korea, (3) further sanctions through the UN and (4) continuing deployment of the THAAD anti-missile system in South Korea. If this is not enough, military intervention cannot be ruled out ultimately.
A further escalation of the US-NK crisis will be negative for risk sentiment – especially in Asia. It is also negative for commodity prices and the JPY and CNY, while it should be positive for bonds, USD and gold due to safe haven flows. If it comes to a war, the effects could be significant – at least for a period of time.
