North Korea and President Trump, High Drama

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Breaking: Japan’s Topix falls 1.4% as yen firms in face of rising North Korea tensions.

On Tuesday, the CBOE Volatility Index surged nearly 12% percent after President Trump was quoted saying further threats from N Korea would be met with “fire and fury.”

One Month Look at Stocks in Japan

Overall, stocks in Japan are 3% off their recent highs.

Earlier reports of a Defense Intelligence Agency analysis indicating Pyongyang has successfully developed a miniaturized nuclear warhead that could fit onto its missiles sent a chill through markets.  The yen surged with gold, while crude dipped below $49 a barrel.

First Time – Long Time

For the first time since June, S&P 500 futures drop greater than 1%.  Per CNBC, the Dow Jones industrial average climbed for 10 straight days, through Monday, for its second winning streak of 10 days or longer this year (after its 12-day win streak in February). That means that 2017 already marks the first year in which the Dow has had two winning streaks of 10 sessions or longer since 1959.  Geopolitical risk is now poised to upset this apple cart.

We believe the Pentagon is considering a request from South Korea to allow it to develop more powerful ballistic missiles as tensions with North Korea continue to escalate.

“There is currently a limit on the warhead size and missiles that South Korea can have and yes, it is a topic under active consideration here,” Pentagon spokesman Capt. Jeff Davis told reporters at the Pentagon, as reported by Reuters.

Cost of Default Protection in South Korea Continues to Surge

This year, Asia’s stock and credit markets have been flashing bullish signs. Per Bloomberg, outside of Japan it costs less to insure Asian corporate and government debt than at any time since before the financial crisis – see the white line above.  Meanwhile, the MSCI AC Asia Excluding Japan Stock Index is near a 10-year high.   On the other hand, geopolitical risks coming at markets from North Korea are raising the cost of default insurance on countries like South Korea – see the orange line above.  Markets depend on continued economic growth and the importance of the region in global debt markets supports stability in CDS prices – but geopolitical risks could turn all the goodwill upside down.  As you can see above, for much of the last five years the cost of default protection in Asia rose with South Korea – high correlation was the name of the game.  In recent months, as Asia credit risk has improved – South Korea continues to deteriorate at an alarming pace.

Council on Foreign Relations

North Korea is believed to have between fifteen to twenty nuclear bombs and has successfully tested a series of different missiles, including short-, medium-, intermediate-, and intercontinental- range, and submarine-launched ballistic missiles. In July 2017, the regime conducted two intercontinental ballistic missile (ICBM) tests capable of carrying a large nuclear warhead. The Pentagon confirmed North Korea’s ICBM tests and analysts estimate that the new missile has a potential range of 10,400 kilometers (6,500 miles) and, if fired on a flatter trajectory, could be capable of reaching mainland U.S. territory. U.S. analysts and experts from other countries are still debating the possible nuclear payload that the ICBM could carry.  “Prior to these tests, North Korea had conducted five nuclear tests: in October 2006 and May 2009 under Kim Jong-il; and in February 2013 and January and September of 2016 under Kim Jong-un’s leadership. Future nuclear tests are anticipated. North Korea possesses the know-how to produce bombs with weapons-grade uranium or plutonium, the primary elements required for making fissile material—the core component of nuclear weapons.” CFR

The Bear Traps Report

We still believe Beijing has a prominent role to play.  Behind the scenes, the US is likely attempting to delegating the North Korea regime change to China.  As a colossal trading partner, China has substantial leverage over North Korea’s generals.   Of course, China likes idea of having buffer in peninsula facing the West, she won’t sacrifice that even if Kim Jong-un is a madman.  Ahead of their coveted 19th Congress this October – war is not in China’s interest at all.  North Korea knows this, helps explain their elevated and annoying resolve.

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