The last week has seen the risk of conflict between the US and North Korea rise dramatically, with President Trump threatening the hermit nation with “fire and fury” should they continue to provoke and threaten the US.
North Korea subsequently responded with talk of attacking US soldiers based in Guam, which AMP Capital chief economist Shane Oliver notes has caused a reaction in global markets, with share markets taking a fall while bond and gold prices go up as investors seek less risky investments.
“This all reminds me of something out of James Bond — or rather Austin Powers — except that it’s serious and naturally has led to heightened fears of an imminent military conflict,” he said.
“How it unfolds from here is unclear but it does seem that the North Korean issue after years of escalation and de-escalation may come to a head soon.”
Mr Oliver suggested investors should consider three potential scenarios for how these tensions play out.
A diplomatic resolution
Much like the Cuban Missile Crisis in 1962, Mr Oliver said it’s likely the two nations will reach a diplomatic solution rather than engage one another in conflict.
Mr Oliver said the “sabre rattling” will likely continue, and even intensify, before this resolution is achieved, at which point share markets will likely see a 5 to 10 per cent correction before rebounding.
Brief and contained conflict
A military conflict without “a full-on ground war or regime change” is another possible outcome, Mr Oliver said, comparing this scenario to the 1991 and 2003 gulf wars — neither of which affected share markets greatly.
“In both gulf wars while share markets were adversely affected by nervousness ahead of the conflicts they started to rebound just before the actual conflicts began,” he explained.
Significant military engagement
The third possible outcome, and one which Mr Oliver predicts would be more likely than a brief and contained conflict, is a full-blown military offensive.
“A contained gulf war style military conflict is unlikely as North Korea would most likely launch missile attacks against South Korea (notably Seoul) and Japan causing significant loss of life,” he said.
Should the tensions between the US and North Korea give way to a significant conflict, share markets will likely see falls of 20 per cent or more “before it became clear that the US would prevail”, Mr Oliver explained.
Mr Oliver anticipates that of the three potential scenarios, a diplomatic solution is the most likely outcome.
“Given the huge risks in terms of the potential loss of life in South Korea and Japan as North Korea would initially respond to any attack on its soil, diplomacy remains the most likely path,” he said.
“In this context Trump’s threats along with the US’ show of force earlier this year in Syria and Afghanistan is designed to warn North Korea of the consequences for them of an attack on the US or its allies, not to indicate that an armed conflict is imminent.”
Until such a solution is reached, market volatility could increase as uncertainty continues to influence markets.