War Risk and Markets

Author: David R. Kotok, Post Date: August 14, 2017
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“Geopolitical tensions reared up last week and eclipsed key fundamental data points. The escalating war of words between the US and North Korea resulted in a textbook flight to safety into bonds, and also provided an excuse to take profits on equities, especially after the Dow posted nine straight record highs. So far, the tensions between the US and North Korea have only impacted the financial markets. But, growth is likely to slow, particularly in Asia, if the uncertainties over a possible armed conflict cast a dark shadow across the region.” (Summary by Action Economics, August 14 – actioneconomics.com)

For a discussion of North Korea and geopolitical and war risk, see our commentary entitled “War?”: cumber.com/war/. We thank readers for their many and diverse emailed views.

Some asked if the market reaction was rational. Others wanted to know if we are “buying the dip.” Still others inquired if this war risk would change the outlook for the Fed and for interest rates.

Answers:

We think it is too soon to buy the dip. There are too many scenarios, and all are uncertain as we write. They range from a coup that removes Kim, followed by North Korea’s opening dialogues (markets would soar), to a shooting war (markets would tank in a rapid sell-off). There would be no time to reposition in either case. Either is possible, but both are outliers to mainstream opinion.

Without an event as a catalyst, we believe the Fed stays its course of gradualism, which means announcing QT in the next month and starting implementation by year-end. They will advance by baby steps. And the Fed will pause its gradual rate hiking so as not to have two QT functions active simultaneously. At most, year-end 2017 short-term interest rates look to be a quarter point higher than they are today.

The more difficult issues to determine are how much slowing will occur due to war risk and where the cost pressures are. Example: Maritime insurance cost rises when military risk is heightened. So shipping rates increase, and those higher costs are passed through the supply chain. Note that this is a supply-chain inflation of price, but one imposed by elements that are not monetary or consumer demand-driven. Thus higher costs attributable to rising risk are a factor that reduces growth.

Readers may use their imaginations to identify many other aspects of the global economy that are affected by war risk.

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