Tensions on the Korean peninsula date back to World War II and, later, the Korean War in the early 1950s, which saw the North invade the South to unify the peninsula but the conflict ended in a stalemate and was never truly resolved. China and the Soviet Union sided with the communist North, while US and UN troops defended the South.

The current situation

Recent escalation has come after nuclear and missile tests by North Korea which Kim Jong Un (3rd generation of the Kim dynasty) sees as paramount to the survival of his regime. The US responded with UN sanctions and joint military drills with the South, as well as President Trump’s ‘fire and fury’ warning. Beneath these exchanges, however, is the realisation that leaning on China to contain/disarm the North has not worked and prior aid-for-disarmament deals have only allowed things to get to this point.

Still, one would be naive to think the world was a safe place without these developments. To put this in perspective: India and Pakistan are nuclear states with a history of friction; US and Russia have the largest stockpiles of warheads and these have been around since the Cold War; and, as a South Korean journalist pointed out, some people are just as afraid of Trump owning nuclear weapons as Kim owning one.

At risk of over simplifying, China’s stance is pivotal given its importance to North Korea.  North Korea is very reliant on China with 75-80% of its exports going to China and 100% of its oil from China.  Back in the Korean War, China came to North Korea’s defence only after US-UN-South Korea forces pushed northward with momentum through the 38th parallel, i.e. once it felt threatened. While China would prefer a non-nuclear neighbour, the truth is Beijing wants a buffer zone between itself and the democratic South Korea and Japan, which host US military bases. A recent editorial in the Chinese media suggests China would once again side with North Korea if the US was to strike first, but it would stay neutral if vice versa. A clear announcement of such position by China would lower the likelihood of a preemptive strike by the US.

Given China’s strong preference for stability, the base case is for the status quo to continue. We listened to an update on North Korea with former US National Security Advisor Stephen Hadley and Mr Hadley suggested the likely outcome is the world will have to live with a nuclear armed North Korea.

But one cannot rule out the possibility of a mistake, an event that leads things to spiral.

What’s this mean for investors?

For investors, a diversified portfolio across asset classes (fixed income and shares), industries and geographies provides a degree of risk management. Also, active managers have additional tools that help protect capital in a bad scenario.

Meanwhile, the fundamentals of earnings and interest rates continue to be supportive for dividends and share prices. As the table below illustrates, world markets have seen geopolitical events before and returns after such events vary. Over time, investors have been rewarded for staying invested during these situations. Historically, geopolitical events like the Korean situation drive volatility in share markets but over the long run what matters most to investors is economic growth and company profits.

Table of historical US market returns after notable geopolitical events

Source: Bloomberg, Strategas Research