What happened?
North Korea escalated the crisis with US, Japan and South Korea over the weekend with another nuclear test. It supposedly had a yield of 100 kilotons, 10 times the power of the nuclear test done one year ago. Ahead of the explosion North Korea launced a video showing Kim Jong Un around what they said was a nuclear warhead capable of being mounted on an Intercontinental Ballistic Missile (ICBM). North Korea in July tested two ICBM that was judged to be able to reach the US.
A nucelar test has been one of the ’red lines’ that the US has mentioned that would trigger action, see also our piece earlier this year: Research: The rising risk from North Korea – and what it means for markets, 27 April 2017
US President Donald Trump and his administration reacted strongly indicating still that a military option is on the table and looking for North Korea to get isolated from trade. One option mentioned by the administration was to not trade with any country that has trade with North Korea.
The market impact has been fairly muted overnight: Asian bourses are mostly lower by close to 1% but the Chinese onshore market is slightly up. The market does not seem to expect the crisis to escalate into war and previous escalations have only had short-lived market effects.
Our quick view:
While the nuclear test is a further escalation we still see war as a low probability outcome as the effects would likely be detrimental. The US Defence Secretary James Mattis said earlier this month a war with North Korea would be catastrophic.
However, whenever brinkmanship is in play there is always a risk that some error occurs and things get out of hand with a tit-for-tat pattern. But none of the parties in the conflict has an interest in war. North Korea is likely feeling threatened by the US and South Korea given the rhetoric of ”all options on the table” and military games going on between US and South Korea. Hence Kim Jong Un’s response has been to show the US that North Korea would meet any military strike with a significant retaliatory response and indicate that North Korear would have the capability of reaching the US as well with a nuclear warhead.
On the other hand the US and South Korea aims to show North Korea that any misstep from North Korea could lead to total annihilation of the regime. James Mattis said on Sunday that the US wasn’t planning for the ”total annihilation” of the rogue regime even though it has ”many options to do so”.
What’s next?
It’s of course hard to predict and we are by no means military analysts. But our view is still that we will see a continuation of regular escalations but with a low probability of war.
The US will likely aim to isolate North Korea and cut them off from trade completely. They may not get full backing for this from China and Russia and we could see increasing tensions between US on the one hand and China and Russia on the other. The risk of US trade sanctions on China is moving up. This would have a negative impact on both the US as well as the Chinese economy. And thus the global economy.
We don’t expect North Korea to back down from their nuclear ambition. They simply see the nuclear deterrence as the only guarantee of the regime’s survival from a US attack. Sanctions are not likely, in our view, to stop North Korea. At the same time there is no easy solution for Trump to stop North Korea. The crisis will likely continue for some time. While Trump has denied that talks can be on the table it’s hard to see how this can be stopped militarily. For now, though, Trump aims to show that his military threat is credible – even if it’s not.