What do North Korea’s nuclear ambitions mean for markets?

The war of words with North Korea is escalating fast.

It seems that the country detonated a hydrogen bomb at the weekend. This is its sixth and most powerful nuclear test, according to claims by North Korean state media.

It might be bluffing, but it seems unlikely. The claim lines up with earthquake data recorded in the area.

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There are obviously many facets to this story, some of them more important than others.

But finance and investing are my patch, so the question I'm asking today is: what sort of impact does history suggest we can expect this to have on markets?

North Korea's long history of nuclear ambition

Here's the rough story so far. No one except North Korea wants a nuclear-armed North Korea. Over the past ten years or so, the rogue state has made several deals to abandon its nuclear efforts in exchange for economic aid or an end to sanctions. It's broken them all.

As a result, the country has managed to continue making progress towards attaining nuclear weapons. It has detonated six nuclear bombs (assuming the one this weekend was genuine, which seems very likely).

But what is has lacked is the ability to make a nuclear warhead that's small enough to put on a missile ("miniaturisation") and fire at someone else.

The problem now is that it's looking more and more as though North Korea is either on the verge of a breakthrough, or has already broken through. The bomb they just tested was their biggest yet. They also now have missiles that are capable of reaching US soil.

Unsurprisingly, this has led to a ratcheting up of the rhetoric on both sides. US president Donald Trump has talked of unleashing "fire and fury" on North Korea. In return, North Korea threatened the US territory of Guam, in the west Pacific.

In response to the latest test, US defence secretary James Mattis has said that the US will respond to any threat against it or its allies "with a massive military response". There will probably be more sanctions too.

But no one expects this to be the end of it. South Korea is girding itself for more launches, with the deployment of a controversial missile defence system (controversial because China objects to its potential for spying beyond China's borders). Meanwhile, Japan is talking about beefing up its own defences.

Markets, unsurprisingly, are rattled. "Safe haven" assets such as gold are higher, as are US Treasury bonds (driving yields lower). Meanwhile, stocks have taken a knock the otherwise apparently unstoppable US stockmarket (as measured by the S&P 500) hit a peak of near 2,500 on 8 August, and has yet to regain that ground.

So what's next?

War, unsurprisingly, is not the best way to generate economic growth

The truth is that it's very hard to make a lot of generalisations about the effect of war or the threat of war on markets. A lot of it depends on the country you're looking at (and whether it won or lost the war in question).

John Authers of the Financial Times summed it up well when he said in a recent column: "Wars are dangerous gambits. If they are swift and not too damaging they can boost growth, and create investment opportunities once it is clear who will win. But there are better, safer ways to grow an economy or make money."

It's also very difficult to split out the broader economic backdrop from the war itself. For example, the start of the second Gulf War in March 2003 coincided with the end of the post-dotcom bear market. The former grabbed all the headlines, but the latter was far more significant in terms of where the market went next.

And there are certainly no real parallels for a nuclear exchange. At first, the Cuban missile crisis of October 1962 looks like the closest analogy. You might find it hard to believe, but this had barely any effect on the US stockmarket.

However, again, the Cuban missile crisis came at the end of a year in which US stocks had already suffered a pretty disastrous decline, sliding more than 20% in the first half (this is sometimes known as the Flash Crash of 1962, apparently).

In any case, the two situations are not really comparable. The Cuban missile crisis was binary in nature. Either it ended well, or it didn't. If it hadn't ended well, the outcome was World War III the end of the world, mutually-assured destruction scenario that anyone who grew up prior to the 1990s will remember as an ever-present background noise.

This scenario is very different. This is not two superpowers playing chess across the global map anymore. Instead, you have an unpredictable rogue state which China would probably like to manipulate, but clearly is struggling to do so squaring up to a relatively unpredictable US president.

So the good news is that Cold War-style Armageddon is a highly unlikely scenario here. The bad news is that a rapid return to Cold War-style stalemate is also not on the cards. Instead you have a range of outcomes from a North Korean retreat, to business as usual, to a localised nuclear war and unthinkable refugee crisis. And it could take a while before it's clear which is most likely.

Stay calm and don't rush to hit the "sell" button

What does it mean for your portfolio? Again, like it or not, you should try not to let it distract you, and just stick with your plan. If you were happy with your asset allocation plan three months ago, you should still be happy with it now.

However, what I would say is: don't think about what to sell. Think about what you'd like to buy more of cheaply, and keep cash available for acquiring it.

For example, Japanese stocks (and South Korean ones) are going to take a hit every time this issue flares up. Whatever else people might try to argue that war is good for, being hit with a nuclear weapon is not good for anyone's economy and, unfortunately, South Korea and Japan are the ones most at risk.

But I'd see those sell-offs as buying opportunities. A nuclear conflict is a low-probability outcome and not one that it makes sense to bet on.

On the other hand, this is also why you own gold (and to an extent, cash) just in case those low-probability outcomes actually materialise.

Beyond that, just resist the urge to tinker too much. The biggest risk to your portfolio in 99% of these cases is your own panicky reaction to sensationalist headlines whether it's piling into "safe havens" at the high, or dumping your stocks at the low. Take a deep breath, avoid checking your portfolio during trading hours if possible, and have a plan before you consider anything rash.