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This article first appeared in Personal Wealth, The Edge Malaysia Weekly on August 7, 2017 - August 13, 2017

Just as political woes and populist rhetoric begin to recede in the West, the escalating tensions between North Korea and the US are causing concern among investors, says Vasu Menon, vice-president of OCBC Bank in Singapore. 

Historically, geopolitical crises have had no lasting effects on markets. However, if the situation turns into an armed conflict and the markets panic, this could create a buying opportunity for Asian equities and bonds.

The ongoing war of words between US President Donald Trump’s administration and North Korean leader Kim Jong-un may not result in armed conflict just yet, but it is a risk that markets are unprepared for, notes Menon. 

“In the last few years, the international community has sort of given North Korea a break and it has used the break to build up its nuclear arsenal. North Korea is a risk. There is the potential of military conflict and it is between two highly unpredictable leaders,” he says. 

“We don’t know whether Trump will actually launch a tactical attack on North Korea. If he does, it will be disastrous because it is crucial to remember that unlike Syria, North Korea has a massive arsenal of weapons and it could lead to major casualties in South Korea and Japan because the US has military bases in Japan.

“Both leaders are unpredictable and open to pulling stunts, so this is worrying investors a bit. If something happens and North Korea retaliates, it will trigger a market meltdown because the fallout could be severe. A military conflict between the US and North Korea will spook the markets significantly and cause a sell-off in the equity and bond markets, and gold could rally.” 

Menon adds that a US attack on North Korea could draw China into the fray as the latter is its strongest ally and largest trading partner. “Problems in North Korea could result in an influx of refugees into China, which could strain its already slowing economy. If China supports North Korea in a military conflict, the markets will definitely be spooked even more.

“If Trump launches a tactical attack and North Korea launches one on South Korea and Japan, that will really scare the markets because it is something unthinkable and comes with potentially cataclysmic consequences. The markets are not ready for this.”

On July 31, US envoy to the United Nations Nikki Hayley was quoted as saying that there was no point holding an emergency Security Council session over Pyongyang’s latest intercontinental ballistic missile (ICBM) launch following its repeated violations. North Korea launched two test ICBMs last month, one on July 4 and another on July 28.

Reuters says in a report that the latest test shows that the ICBM may be able to reach most of the continental US. The growing threat posed by Pyongyang’s nuclear and missile programmes could put more pressure on Trump’s administration to respond, it adds.

Menon points out that a tactical attack could serve as a distraction since Trump is desperate to draw attention away from negative news related to his failed attempts at repealing Obamacare, investigations into the alleged collusion between his campaign and Russia before last year’s presidential election and proposed tax reforms, which seem to have taken a back seat.  

Nevertheless, the potential conflict may not result in markets staying down for too long, says the senior investment strategist. “Eventually, the politicians will come together and rationality will prevail.” 

“From everything Trump has talked about, he is not the kind of person who wants to go to war. He has done something in Syria, but that is considered a lame-duck move. Unless he knows for a fact that North Korea’s ICBMs can really hit the US, that might give Trump an excuse to launch a small attack,” says Menon.

“But he knows if he does that, the 33-year-old Kim might do something crazy. So, I think Trump’s first option will be tighter sanctions and putting pressure on China to rein in North Korea, possibly using the threat of trade protectionism to get Beijing to act.”

Here is where China comes into play, he points out. It has not flexed its muscles at North Korea and as long as it does not shift its focus from its economy to warfare, the bad news is not expected to prevail. 

“So far, China has not showed its power over North Korea. But if that happens, I think it will rein in North Korea because it is not in China’s interest to see war in the Korean peninsula,” says Menon.

“China is trying to fight corruption in the country and trying to make sure its economy is dealing with issues such as debt. And with the Communist Party’s election taking place in October, I don’t think President Xi Jinping is interested in a war.”

Other tensions

Despite Trump’s waning popularity for not being able to deliver on campaign promises of deregulation, tax reforms and ambitious infrastructure spending — which bolstered an equities rally in the first half of the year — US corporate earnings are better than expected while the data out of all major markets have showed improvements, says Menon.

“It just means that in the second half of the year, the markets will find it more challenging to perform than they did in the first half. The first half was exceptional — stock markets in Asia ex-Japan, for example, went up 20-odd per cent. The global bond markets also did relatively well, having gone up 5% to 6%,” he says.

“All the economic data coming out of major developed markets showed a very big pick-up. That was partly because China was pump-priming its economy, the US was on a recovery path, there was a wave of technology spending and commodity prices rebounded, which resulted in a lot more economic activity that surprised the markets. The earnings also surprised the markets as they were better than expected. 

“The second half of the year will be a bit more challenging because a lot of people expected Trump to deliver on tax policies. He will not be able to do that. But what is scarier is that when China and the US sat down to discuss trade, the first few meetings were frosty and they were not even able to hold a press conference. 

“At the back of investors’ minds is whether Trump will pull out his protectionism card because he has already labelled China a currency manipulator. But now, I think with China not really cooperating on North Korea and Trump facing domestic political pressure with the Russian scandal, he is starting to focus on protectionism, which could serve as a distraction.” 

The bond markets have benefited because despite all the good economic data, no one felt that the US Federal Reserve was in the mood to increase interest rates too sharply just yet, says Menon. Looking at the macro environment, with the economic momentum in developed economies already showing signs of stalling, the moderate growth conditions do not indicate a recession in developed markets, he adds.

“We do not think a recession is on the cards, at least not anytime soon. Most developed economies’ fiscal policies are roughly neutral while their monetary policies are still very accommodative, which means that the current expansion should continue,” says Menon. 

The downside risk is that if there is a reversal in the accommodative monetary policies, there will be a rapid increase in interest rates. “Another potential source of downside risk may just be expectations. With developed market stocks selling at higher multiples of corporate earnings versus their long-term historical average, earnings expectations are clearly stretched. Whether companies are able to meet such lofty earnings expectations in subsequent quarters remains to be seen. But if moderating economic conditions are any indication, earnings could be restrained as well after a robust first half,” says Menon.

“Ultimately, stretched valuations in the face of continued political and economic uncertainties argue for some caution ahead. Yet, everything in moderation. Holding too much cash as a defensive strategy may risk long-term harm through underinvestment and an erosion of purchasing power due to inflation. Thus, a safe option would be to ensure long-term market participation through an adequately diversified portfolio.”

This is a decidedly simple approach to navigating potential turbulence ahead while not sacrificing exposure to the potential broader market upturns. This allows long-term returns to be enhanced without necessarily taking uncomfortably high levels of risk. 

Europe remains a moderate risk for investors at this juncture, says Menon. Though the parliamentary elections in the Netherlands and presidential elections in France saw a rejection of anti-establishment and nationalist economic policies, the tables may turn in the upcoming general elections in Germany and Italy. 

“People are giving German Chancellor Angela Merkel the benefit of the doubt. At some of the local elections in Germany, her party has done quite well, so people feel that the populist movement has taken a back seat and Merkel will win. Then again, after the US presidential election and Brexit last year, no one is prepared to write it off completely. Clearly, in the run-up to September and October, the markets will show some signs of nervousness,” he says. 

What should investors do then? Menon says the global equity and bond markets have gone up by 181% and 35% respectively in the last decade. “This was achieved despite the global financial crisis, European debt crisis, plunging oil prices and other commodities, a slowdown in China, taper tantrums in the US and volatility in emerging market currencies. If you had just watched the headlines and got spooked by every piece of news, you would not have bought anything and you have missed out on the 181% gain.

He says it is high time investors came to terms with the fact that there is a new world order, where uncertainty is a fixture. “Going forward, it still makes sense to invest in the markets, but investors will have to do it in a smarter way. Instead of trying to time the market, they should invest gradually over the next 12 months. If you have US$120,000 to invest in the market, you can put in US$10,000 every month, as opposed to putting the whole sum in at one go. 

“The outlook for equities in the medium term still looks quite positive. Economic recovery is taking hold in most parts of the world and that augurs well for equity markets. However, the valuations of equity markets are not very compelling. The risk is that they are prone to bad news. It does not mean that the bad news will cause a crash. It probably means there will be a pullback before the uptrend resumes. It is really a matter of spreading your bets.

“We prefer equities for the medium term. In particular, dividend-yielding stocks are a popular option for investors looking for income. If you have done well in the equity markets and have a lot of exposure to stocks, it is a question of looking at reducing your equity holdings and putting more into bonds, hedge funds and alternative assets. I think one needs to have that spread.”

With the European economic data picking up, equities — especially those in the financial sector — will gain traction, says Menon. “If we compare the European stock markets’ performance against those of the US, you will see that over the last 5 to 10 years, Europe has really underperformed. So, on a relative basis, Europe offers value.

“The European stock markets’ price-earnings ratios are not cheap, but because the US has done so well, money could rotate out of the US and into Europe. Once the elections in Germany and Italy are out of the way, we will have a better idea of what will happen to the economy. Then I think investors may turn more positive on Europe. 

“If you are a medium-term investor of three years, then I think Asia ex-Japan is a good bet. In the last six months, Asian equities have been the best performing asset class, followed by European, US and Japanese equities. 

“Japan’s gains have been single digit, but Asia’s gains reached 22% in terms of its stock market performances. That is because expectations are very low due to worries about China’s economy slowing down, Trump’s protectionist threat and the strengthening US dollar. These risks did not materialise, so Asian markets did well in the last six months.  However, there is still value in Asia in the medium term as the markets have underperformed their developed market peers.” 

He recommends looking at both Asian equities and corporate bonds as more companies are issuing these securities. “Corporate debt is creating opportunities. Standard & Poor’s recently upgraded Indonesia’s sovereign bond rating to investment grade. It is an indication that the Asian bond story is starting to gain traction.”

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