Following six nuclear tests since 2006 and several missile launches in 2017, Pyongyang may have reached a point to conclude its military advances with a nuclear restraining credible enough to discourage the US from attacking North Korea. While Pyongyang could now start to negotiate from a stronger position, thus far there have been no signs of negotiations. Should there be a conflict, it remains unclear if it will be restricted to the Korean peninsula or spread to the region.

We believe a conflict will immediately affect South Korea and Japan. It will cause disruption to the Korean manufacturing industry i.e. semiconductors, automotive and shipbuilders and affect the global supply chain. Japan’s electronics are manufactured in China but there is a significant presence of US troops in Japan. Malaysia’s GDP will be affected by a slowdown in South Korea and Japan’s exports performance due to the disruption in the global supply chain.

We are negative on the global financial markets, but positive on US and European bonds as well as currencies due to their safe haven status and the euro being less politically risky. We are negative on Japan and AxJ’s bonds and currencies if Japan is involved directly in the conflict as it raises the credit risk but positive on Japan if their involvement is indirect due to its safe haven status.

We also examined the impact from the short-run shocks arising from South Korea and Japan’s financial assets on our financial assets which could result in a misalignment in the long-run equilibrium. Our aim is to determine the speed of adjustment back to the long-run equilibrium. If the adjustment is fast, the impact on our financial market will be short-lived while a slower adjustment will lead to a longer recovery.

From our findings (summarised in Tables A and B), the key indicators we need to observe closely with respect to shocks arising from South Korea are: (1) the KOSPI; (2) the won; and (3) South Korean government 3-year, 5-year & 10-year yields. In the case of Japan, we need to watch closely the movements of: (1) the Nikkei; (2) Japanese government 3-year, 5-year & 10-year yields; and (3) the yen.

Source: AmInvest Research - 11 Dec 2017