ECONOMIES Asia

Revisiting North Korea tail risks

While we have increased moderately the probability of the tail risk scenario for North Korea (military conflict), it remains a low probability event.

Still discovering a new geopolitical balance
Geopolitical tensions have once again sparked financial market volatility. The US and North Korea remain in irreconcilable positions as Pyongyang remains firmly committed to its nuclear missile program. While a military conflict between the two nations is a tail risk, we think war will be avoided and expect financial markets to swing back and reflect underlying business conditions.

First, from a game theory perspective, war can be avoided if both sides have “credible threats” in place as a deterrent to striking first. Periodic swings in tension are likely here to stay, however, as each party has an interest in building up its military presence, enact trade sanctions and use threatening language.

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Second, and more important, is the mediating role of China in avoiding conflict. The UN Security Council passed a new round of sanctions on the North Korean regime after the intercontinental ballistic missile (ICBM) tests in July, which China has committed to fully implement. The sanctions involve potential export losses for North Korea of up to USD 1bn. To effectively enforce them, the US is likely to exert ongoing leverage over China in future trade negotiations.

Tail risk probability up from very low to low
Our three previously highlighted risk scenarios on the North Korea conflict remain intact. The first scenario is a status quo situation, in which relations muddle through without any escalations and with fresh diplomatic solutions. Our second scenario expects temporary escalations, potentially due to tighter sanctions by the US and China on North Korea, with tensions fading and normalcy returning soon. The third is a tail-risk scenario that envisages a sharp rise in tensions due to a military conflict likely lasting for 3–6 months, but without nuclear capabilities being deployed by either side.

With the recent sanctions and both the US and North Korea exchanging threats, we have moved to the second scenario, resulting in a moderate increase in the probability of our tail-risk scenario from very low (<10%) to low (10–20%). However, we still view a US military campaign against North Korea as highly unlikely.

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Stay invested with some hedging options
Tail risks are improbable, but investors must address the potential downside risk. In the event of a military conflict, we would expect a negative market reaction in the region. Asian assets would sell off, with equities (–20%), credit (–8%), currencies (–5 – 10%) and commodities (–10%) all plunging, in our view. But this is a low-probability scenario, so investors who position solely for a tail risk would miss out on the market’s strong fundamentals.

We believe the global economy is still solid, supported by a benign monetary policy and muted inflation. Asia stands out with its solid economic and corporate fundamentals, and we expect robust double-digit earnings growth both in 2017 and in 2018. We thus remain overweight global equities relative to bonds.

We have also devised a list of five Asianrelated opportunities with 3–6-month time horizons that could offer returns in both our base case and tail-risk scenarios:

  • Long Chinese equities versus short Taiwanese equities
  • Long Indonesian equities versus short Philippines equities
  • Buy USDAUD
  • Buy USDSGD
  • Long gold/silver versus base metals

The two equity trades have historically delivered strong performances during global risk-off periods, and we think this could remain the case for South Korea. While China’s economy is strong as domestic liquidity is healthy, Taiwan’s prospects remain muted in the near term. A rebound in Indonesian consumption in 2H17 should drive earnings strength, while valuations in the Philippines seem rich relative to its regional peers.

We hold a negative view on the AUD and the SGD due to domestic headwinds amid a rising USD yield environment. Further, these two pairings could act as a hedge in the tail-risk scenario. The AUD and the SGD tend to underperform the USD during risk-off conditions, with the former being more vulnerable.

Meanwhile, investors who are uncomfortable with the ongoing geopolitical risks could also consider hedging their portfolios via put options on the Hang Seng China Enterprises Index or the Taiwan Stock Exchange Weighted Index. Option prices are relatively attractive on both indexes, given they tend to sell off more violently during risk-off periods than their developed market peers.

We expect the situation on the Korean peninsula to remain fluid for the next few weeks, and recommend investors to monitor the developments closely. Nonetheless, we do not expect any extreme market moves. Given the strong economic backdrop and corporate fundamentals, we still prefer risky assets in a well-diversified portfolio.

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Adrian Zuercher - Head APAC Asset Allocation - UBS
Sundeep Gantori - Analyst - UBS
Philip Wyatt - Economist - UBS

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