- Mounting tensions between the US and North Korea threw markets for a loop on Thursday before settling on Friday. Now risk assets are at a critical juncture.
- While the market reaction was swift and punishing, market experts don’t think it’s time to panic — yet.
Mere days ago, risk assets looked unstoppable. Now, amid escalating tensions between the US and North Korea, the market finds itself at a crucial crossroads.
The mounting conflict came to a head on Thursday, fuelled by some fiery rhetoric from President Donald Trump and aggressive threats from North Korea, serving as a reckoning of sorts for some of the world’s most closely-watched markets.
The S&P 500 snapped out of an unprecedented streak of calm that day, falling 1.5%, the most since May. Treasury yields took a dive, while the yen — generally viewed as the world’s haven currency — strengthened. Gold, the ultimate safety destination, surged to a nine-week high. Meanwhile, the CBOE Volatility Index — or VIX, a gauge of stock market fear — spiked more than 40%.
“You just needed a match to light the fire, and that’s what North Korea did,” Komal Sri-Kumar, president of Sri-Kumar Global Strategies and the former chief global strategist at Trust Company of the West, told Business Insider by phone. “You didn’t have any ongoing stimulus measures, and at the same time we’re in an overvalued market. The market was all set for perfection, and it was no longer perfect, so we got a big decline.”
Then, on Friday, risk assets turned in a meager recovery, with stocks and Treasury yields rallying early in the session before petering out into the weekend.
That they didn’t rebound in fuller fashion isn’t particularly surprising to Kumar, who sees the market bunkered down in wait-and-see mode, not wanting to make any sudden movements that could be derailed by a new development out of North Korea.
Now, he views the path forward in the immediate term as a binary outcome. One possible result involves US officials scaling back the level of rhetoric, which would quickly move the market back to stability, lowering the price of gold and boosting stocks back toward record highs.
On the flip side, further goading by either the US or North Korea would ratchet tensions even higher, leading to further pain for risk assets. The price of gold will swell, while equities and Treasury yields could drop well below the levels they saw on Thursday, Sri-Kumar says.
If recent history is any indication, investors may view weakness in risk assets as an attractive entry point for buying more. This has been particularly true for US stocks during their ongoing eight-year bull market.
Back in May, the S&P 500 took just two days to almost fully recover from its biggest drop in eight months. The dynamic also played out in June 2016, when stocks sold off following the UK’s decision to leave the European Union, only to make it back in a week. Not to mention China’s unexpected currency devaluation in August 2015, which saw the S&P 500 rebound from a 11% correction in a mere two months.
“The market’s buy-on-dips conditioning is strong,” Mohamed El-Erian, the chief economic advisor at Allianz, told Business Insider. “As such, it would take a worsening of the North Korean tensions to amplify the pressures on the VIX.”
Brad McMillan, chief investment officer of Commonwealth Financial Network, which oversees $US114 billion, is similarly optimistic. He says we’re “probably not that close yet” to any sort of world-altering conflict. And while he acknowledges that South Korea will feel the biggest impact from any escalation, he doesn’t see US military action directly affecting US companies or corporate earnings.
Still, he recognises that we’re talking about some highly volatile elements — most notably Trump and North Korean leader Kim Jong Un, but also increasingly fragile financial markets characterised by crowded trades and abnormally low volatility.
“The chances are high that after a short-lived pullback, markets will recover,” McMillan wrote in a recent blog post. “Although risks are rising, they are not immediate. That said, we do need to keep an eye on this situation, as it really could be different this time.”
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