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The rising risk from North Korea
- and what it means for markets
27 April 2017
Chief Analyst
Allan von Mehren+45 45 12 80 [email protected]
Investment Research Important disclosures and certifications are contained from page 18 of this report.www.danskebank.com/CI
Brinkmanship:
‘The ability to get to the verge without
getting into the war... If you cannot
master it, you inevitably get into a war.
If you try to run away from it, if you are
scared to go to the brink, you are lost.’
1956, John Foster Dulles, Secretary of State during the cold war under US president Dwight Eisenhower
22
• 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.
Key takeaways
A dangerous game of chicken is going on between the US and North
Korea – this is a key risk factor for markets this year
33Source (both charts): Bloomberg, CNN, Danske Bank
• The crisis with North Korea has intensifiedduring the reign of Kim Jong-Un, as he has accelerated the number of missile tests and nuclear tests. His aim is to get an ICBM with a nuclear warhead that can reach the US.
• A submarine-launched ballistic missile with a nuclear warhead would also be able to reach the US.
• The US has been clear that it will not allow thisto happen and has stated that the era of ‘strategic patience is over’.
North Korea getting closer to ICBM, which could reach the US
‘We have reached the final stage in
preparations to test-launch an
intercontinental ballistic rocket’
Kim Jung Un, New Year Speech 1 January 2017
Chief Analyst, Allan von Mehren, [email protected]
44
Crisis to escalate further if/when North Korea does nuclear test
NK has advanced its’ nuclear capabilities• Apart from an acceleration in missile tests, North Korea has also advanced its nuclearcapabilities.
• Five nuclear tests have been done since 2006 with a significant increase in estimated yield in kilotons of the nuclear bombs during this period.
• In 2016, North Korea conducted two nucleartests – the latest on 9 September, two monthsahead of the US presidential election.
• Despite many rounds of sanctions imposed by the UN, North Korea has shown no sign of changing course from becoming a nuclear power with long-ranging missiles.
• To accomplish this, North Korea needs to be ableto increase the length of missiles from intermediate to long ranging, and to minituarisethe nuclear bomb to a warhead small enough to be attached to a missile.
• It is unclear how far along North Korea is with this, but there is no doubt that it has graduallyincreased its capabilities. At some point, it mayreach this stage, unless stopped.
The main trigger to look out for now is a
new North Korean nuclear test. At the
latest missile test, the US administration
said it wouldn’t respond to it but warned
of ‘other actions’ if North Korea
proceeded with plans for a nuclear test.
There have been signs North Korea is
ready for another nuclear test.
Chief Analyst, Allan von Mehren, [email protected]
55
North Korea’s track record with UN is not great
1985
North Korea signsNuclear Non-
Proliferation Treaty(NPT)
1994
NK pledges to freeze and dismantle old nuclear
reactors
2003
NK withdraws from the NPT. Declares it has nuclear
weapons
2005
NK agrees to give up nuclear programme in
exchange for energyassistance and economic
cooperation
2006
NK test fires long range missiles. UN Security Council
pass resolution demandingNK suspend the program
2006
In October, successful test of first nuclear
weapon
2007
NK agrees to close mainreactor in
exchange for aid
2009
NK conducts second nucleartest after Six-Party talks
broke down in December. New sanctions by UN
2012
NK agrees to moratorium of long-
range missilelaunches and nuclearactivity in exchange
for aid
2013
NK conduct 3rd nucleartest (first one under Kim Jong-Un. UN orders new
sanctions
2016
NK conducts twonuclear tests (in
January and September
2017
US Trumpadministration says
era of ‘strategicpatience is over’
Red circle: NK moving
against UN
Chief Analyst, Allan von Mehren, [email protected]
66
Crisis heating up between the US and North Korea this year
China warns a ‘storm is about to break’ on the Korean peninsula after the US supposedly
redirected the USS Carl Vinson strike group towards the South Korean waters. The Chinese Foreign Minister said the situation was on a ‘knife edge’. On the same day, North Korea’s Vice Minister of Foreign Affairs warned that, ‘we’ve got a powerful nuclear deterrent already in our hands, and we certainly will not keep our arms crossed in the face of a US pre-emptive strike’ in a statement to Associated Press. Shortly after, it was reported that the strike group was in fact heading in the opposite direction. However, it has been reported that it could reach the Korean Peninsula by the end of April.,
The US warns of ‘other actions’ if Pyongyang precedes with nuclear test. North Korea launches another ballistic missile that failed. The Trump administration signals that it would hold back from immediate military or diplomatic response but warned of ‘other actions’ if Pyongyang proceeds with a nuclear test. There is speculation that the missile test failure was caused by a cyber attack by the US.
North Korea displays several new missiles at a military parade to celebrate the birth of the nations first leader. The new missiles appeared to show new long-range and submarine-based missiles.
2017
North Korea fires ballistic missile ahead of Trump-Xi meeting. The missile fell into the Sea of Japan. It comes after the US, Japan and South Korea finish naval military drills.
North Korea fires four ballistic missiles into the waters of Japan.
North Korea fires ballistic missiles into waters of Japan during a visit by Japan’s Prime Minister Shinzo Abe to Donald Trump’s Mar-a-Lago.
North Korean leader Kim Jong-Un pledges in New Year speech that NK is close to having an
Intercontinental Ballistic Missile that can reach the US.1 Jan
13 Feb
6 Mar
6 Apr
14 Apr
15 Apr
16 Apr
Chief Analyst, Allan von Mehren, [email protected]
77
A preemptive US strike on North Korea not likely at this stage
Hot spot in Asia – dots show US military bases
Source: www.militarybases.com
• With President Trump’s order of a strike on Syria and the hugebomb in Afghanistan, he has shown a more active role in foreign policy than Barack Obama.
• It has raised the question of whether he will also be more inclined to make a preemptive strike on North Korea.
• However, the case with North Korea is very different from
Syria and Afghanistan.
• Any military strike against North Korea comes with a
significant risk of retaliation that could be very costly in terms
of human lives.
• A retaliatory strike could hit the South Korean capital Seoul which is home to about 10 million people – potentially with a nuclear bomb or nerve gas bombs.
• The US has 28,500 troops stationed in South Korea that wouldalso be an obvious target for retailiation. NK also has chemicalweapons that could be targeted at South Korea and Japan.
• A step down the war path could lead to a big war where the US would have to go for eliminating the regime – and do it fast. If Kim Jong-Un is backed into a corner and believes he will not survive, his actions could become extreme.
• A US strike also needs to be coordinated with South Korea and Japan as key US allies and targets of NK in case of a war.
• The US is now exercising brinkmanship – a term invented by US Secretary of State in 1956, John Foster Dulles. It is a policy where you move to the threshold of confrontation in order to gain an advantageousnegotiation position over your opponent.
• However, it comes with a high risk as the further youmove to the brink, the higher the risk of an ‘error’ thatcould push you over the brink and bring the situation out of control.
• The US has put maximum pressure on NK to make it back down from its nuclear ambitions. However, if thisdoes not work, the US may have to go to war or risklosing credibility – as suggested by Dulles’ quote on page one.
Chief Analyst, Allan von Mehren, [email protected]
88
‘You can get lots of targets — North
Korea has more than a million men
under arms, they've got tunnel complexes,
nuclear sites. Could we throw everything
but the kitchen sink at it? I guess.
But this is also analyzed to death, and
when we look at it, we come to the same
conclusion every time: We would "win a
war," but the price our allies [would pay]
far exceeds whatever the gains would be.
This is why they call [North] Korea “the
land of no good options.’
Jonathan Pollack, Senior Fellow at Brookings Instution, specialize in US strategy in Asia, interview with Vox, 18
April 2017
A war with North Korea would be costly
‘The situation is extraordinarily
complicated and not amenable
to either simple solutions or one-
off ad-hoc interventions
designed to demonstrate
American strength.’
Hazel Smith, Professor at London’s School of Oriental and African Studies, NBC interview
22 April 2017
‘… it should be painfully
clear to everyone that there is
no military solution to the
problem of Kim Jong Un’s
nuclear weapons.’
Fraser Cameron, Director EU-Asia Centre, FT letter 4 April 2017
Chief Analyst, Allan von Mehren, [email protected]
99
How a US plan to stop North Korea might look
‘Since 1992, the United States and our
allies have stood together for a
denuclearized Korean Peninsula. We
hope to achieve this objective through
peaceable means. But all options are on
the table.’
Mike Pence, US Vice President, 17 April 2017
Step 1:
• Show strong force of strength – by sailing in army fleetto waters close to the Peninsula and warn that it intends to act alone militarily if necessary.
• Make it clear to allies South Korea and Japan that the US is 100% behind them.
• Convince China to talk to North Korea and take toughersanctions on trade against the regime (we estimate80% of North Korea’s trade is with China). In February, China banned imports of coal from North Korea for the rest of the year. Coal is the biggest source of foreigncurrency for North Korea, accounting for around a third of exports.
Step 2:
• If step 1 fails to stop North Korean missile tests, the US could aim to shoot down NK missiles when tested.
• If North Korean nuclear tests continue, the US will be in a difficult situation. It could eventually choose a military option in order to not lose credibility.
Hopefully, step 1 will be
enough to stop Kim Jong-Un
from doing more nuclear tests
A new nuclear test by NK
would escalate the situation
Chief Analyst, Allan von Mehren, [email protected]
1010
North Korea’s response to the recent US show of force
‘Nothing will be more foolish if the United States thinks it can deal with us
the way it treated Iraq and Libya, miserable victims of its aggression, and
Syria, which did not respond immediately even after it was attacked.’
Spokesman for the general staff of the North’s People’s Army
The United States was ‘becoming more vicious and aggressive’ under Mr.
Trump and that ‘we will go to war if they choose.’
‘At a time and at a place where the headquarters deems necessary, it [a
nuclear test] will take place.’
North Korea’s vice foreign minister, Han Song-ryol
Chief Analyst, Allan von Mehren, [email protected]
1111
• China is a long-time ally of North Korea’s and has had closediplomatic relations historically. Supported North Korea in the Korean War of 1950-53.
• In 1961, China and NK signed a treaty where China pledged to support NK militarily in case of outside attack.
• In recent years, the relationship has cooled significantly – not least since the current leader Kim Jong-Un came to power in late 2011.
• China has been against NK becoming a nuclear power and has opposed the nuclear tests by NK.
• Since 2003, China was a participant in the six-party talks thatincluded NK, the US, Japan, South Korea and Russia. Thesebroke down in 2009.
• Strategic reasons for China’s support for NK:
o From a security standpoint, NK is an important buffer zone to an ally of the US (South Korea). A reunificationwould lead to a stronger united Korea, likely to be alliedwith the US with US troops close to the Chinese border.
o A collapse of NK would lead to a flood of refugees intoChina.
• China has appealed for restraint and wants a resumption of six-
party talks.
Where does China stand?
‘Xi Jinping stressed that China insists on
realizing the denuclearization of the
Korean Peninsula, sticks to safeguard the
peace and stability in the Korean
Peninsula, advocates to solve problems
through peaceful means, and stands ready
to maintain communication and
coordination on the Korean Peninsula
issue with the US. ‘
Statement from China’s foreign ministry
following phone conversation between Xi
and Trump on 12 April
Chief Analyst, Allan von Mehren, [email protected]
1212
• Trump has previously been a strong critic of China, saying China could control North Korea if it wanted. However, after the summit between Xi and Trump in Mar-a-Lago, his tone has softened on this.
• According to some sources, China has attempted to talk to North Korea in
April but North Korea is not answering back.
• China’s Special Representative for Korean Peninsular Affairs, Wu Dawei, visited Pyongyang in February 2016 in order to urge restraint after North Korea announced a plan to put a satellite into orbit with a long-range rocket. Two days after his return to Beijing, NK launched the rocket.
• Kim Jong-Un has removed people with whom China has had a good relationship – among these were Kim Jong-Un’s uncle and brother, who were executed and assassinated, respectively.
• Chinese president Xi Jinping has not yet met North Korean leader Kim Jong-Un during his time as China’s president since 2013.
• China has also backed UN sanctions against North Korea, taking the side of the UN rather than North Korea. China’s coal imports from North Koreawere banned in February for the rest of the year.
• At the Xi-Trump meeting, Xi is likely to have agreed to work with the US and squeeze North Korea further economically, in our view.
• However, China does not believe sanctions alone can solve the issue and wants negotiations back on the table. So far, there is no sign that sanctions are tempering North Korea’s military ambitions. They could even reinforce these ambitions if North Korea feels more convinced it will be attacked without nuclear deterrence.
China’s leverage over North Korea may be overestimated
80% of North
Korea’s trade
is with China
Chief Analyst, Allan von Mehren, [email protected]
1313
• Kim Jong-Un came to power in 2011 when his father Kim Jong-Il died. His grandfather Kim Il Sung was the ‘supreme leader’ and founder of North Korea in 1948.
• Kim Jong-Un has accelerated North Korea’s missile and nuclear programme and is determined to make North Korea a nuclear power with missiles able to hit the US with a nuclear warhead.
• Jong-Un sees a nuclear arsenal as deterring the US from attacking NK, thus securing the survival of the regime (and himself). He has seen Libya’s Gaddafi give up a nuclear programme and later end up dead.
• He has supposedly ordered executions of more than 300 people – among these his uncle in 2013 (who was also his mentor) and most likely his brother who was killed in Malaysia in February 2017.
• It is not clear how mentally fit he is. There are plenty of unconfirmed stories of very brutal executions using heavy weapons, killing a top official for falling
North Korea’s leader Kim Jong-Un – how dangerous is he?
asleep during a meeting and others for not being cheerful enough during speeches. This points to a brutal and cynical leader - as many other dictators before him.
• It is uncertain how dangerous he is –but the US seems determined not to take any risks on this matter and not to allow him to develop weapons that could reach the US with a nuclear warhead.
Chief Analyst, Allan von Mehren, [email protected]
1414
Source: Bloomberg, Danske Bank
• Equity markets: expect the usual risk-off pattern
− A strong rise in the tensions between North Korea and China/US will most likely lead to a correction in stock markets. The extent will clearly depend on how much it escalates but if it comes to war, look for a big correction as investors are generally long risk assets. Asian stock markets would take the biggest hit.
− Expect the usual inflows into lower-beta equity markets: DM to outperform EM, US to outperform within DM vs. Europe and Japan. Within Europe expect Denmark and Switzerland to outperform, and in terms of global sector performance defensives are most likely to outperform cyclicals.
• Bond markets: Safe haven flows to lower yields
− A clear escalation of the situation into a military conflict is likely to trigger safe-haven flows into global fixed income.
− Even though the US would probably be a participant in a potential conflict, we would expect the US Treasury market to
be the main beneficiary due to its sheer size, and as the market will be able to price out future Fed hikes. We would expect the Fed to go on hold and stand ready to provide support if needed.
− In Europe mainly core government bond markets including
Scandi markets would be likely to benefit.
− Semi-core and periphery bond markets could come under
pressure. Global central banks will stand ready to provide especially USD liquidity in case the functioning of the interbank market is impaired. We could see 10Y Bund yields below zero and 10Y US Treasury yields well below 2.0%.
Market implications of escalation – risk-off in equities and bonds
Equity markets not worried so far – an escalation would hit Asian stocks the most
Escalation of the NK crisis would lead to safe haven flows into fixed income, pushing yields lower
Senior Strategist, Christian Tegllund Blaabjerg, [email protected], Chief Analyst Arne Lohmann Rasmussen, [email protected]
1515
Military conflicts increase uncertainty
Senior Strategist, Christian Tegllund Blaabjerg, [email protected]
1616
• FX:
− Don’t expect the ‘usual’ safe-haven moves: A rise in NK tensions should tend to drive safe-haven flows and thus induce a broad-based strengthening of the US dollar sending the USD index higher. But, we stress that EUR/USD is unlikely to decline much given the current status of the euro as a funding currency, and the cross may in fact move higher to the extent that Fed hikes could be postponed.
− The Scandi currencies should be vulnerable to the associated souring in risk appetite with notably the NOK additionally set to be hit by lower oil prices in this instance.
− JPY, another traditional safe haven, would likely depreciate vis-a-
vis majors as a NK strike on Japanese territory would be a real risk. CHF is likely to be the only genuine safe haven in this setting. Asian currencies – not least the CNY and KRW – would weaken in case of a sharp escalation.
− EM currencies more generally are likely to come under pressure. The most liquid EM currencies like ZAR, TRY, MXN will likely be hit In addition, the currencies of base metal producing countries such as BRL, CLP may take a blow.
• Commodities:
− We look for an escalation of the US-North Korean crises to weigh
on commodity prices in general due to negative impact on demand
from fall in risk sentiment and a stronger USD. The impact will
likely be greater in base metals where China consumes half of the world output. However, the price on gold should rise due to increased demand for safe haven assets.
Market implications of escalation - hit to Asia FX and commodities
Metal prices could take a further hit
Source: Bloomberg, Danske Bank
So far little effect on KRW or JPY
Chief Analyst, Christin Kyrme Tuxen, [email protected],, Chief Analyst Jakob Ekhold Christensen, [email protected], Senior Analyst Jens Nærvig Pedersen, [email protected]
1717
• While the US is currently exercising brinkmanship, the bar for a military intervention by the US is very high. A
preemptive strike by the US runs with a very high risk.
• Nevertheless, a further escalation of the conflict is still likely – watch out for another nuclear test by NK.
• Ultimately, the outcome depends on how the game of chicken between Washington and Pyongyang plays out.
The biggest risk is clearly that neither NK or the US backs off and we see a military conflict.
• A further escalation of the US-NK crisis would 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.
Key conclusions
Summary: an escalation is a clear risk – watch for nuclear test
1818
Disclosures
This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S ('Danske Bank'). The author of this presentation is Allan Von Mehren, Chief Analyst.
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1919
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