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Hope is Not a Strategy

August 25, 2017

 

For more than 60 years, the United States and her allies have avoided conflict with North Korea. However recently the antics and volatile personalities of North Korea’s Supreme Leader Kim Jong-Un, and American President Donald Trump, are turning a bad situation into one where the unimaginable has become a distinct, even if remote, possibility: the potential for a nuclear war.

 

The issue now at hand is the actual likelihood of military conflict.  

 

It comes down to one major factor: the recent awareness of, and the willingness to accept the existence of, North Korea’s nuclear weapons technology.  The American government and the international community have tried for years to deter the North Korean nuclear program through aggressive sanctions and diplomatic pressure.  This effort has failed.  The DPRK has now successfully tested five nuclear bombs and several missiles, including two inter-continental ballistic missiles on which to deliver these bombs.  This is the game changer.

 

Spurred by a new set of US sponsored sanctions against North Korea, a war of words has already commenced between two unpredictable leaders, Trump and Kim, leading many to believe that conflict could be imminent.  China is the only country that may be able to keep North Korea at bay. More than 75% of North Korean exports are to China, giving the Chinese significant influence over the North Korean regime. The good news is China has been clear in stating that they will only protect North Korea if the USA strikes first and will not offer any support to North Korea if they were to start the conflict (would likely remain neutral).

 

While the North Korean regime is both erratic and violent, their top priority remains regime security and survival. There is currently no solid evidence to suggest they will undertake a military offensive. They know that attacking the USA would result in their unequivocal destruction.  This is fundamentally why we believe nuclear war or any major military conflict is highly unlikely.  However, a North Korean offensive isn’t the only possible road to war.  There is talk in the Trump administration and amongst more hawkish circles in the USA about the merits of a preventative war in North Korea.  General McMaster recently defined the term as “a war that would prevent North Korea from threatening the United States with a nuclear weapon”.  An American pre-emptive strike against North Korea would result in considerable loss of life and the damaging of US relations in the Pacific and around the world.  Support for preventive war is given by those that deem this a necessary cost to ensure the security of Americans at home.  This path to conflict remains unlikely but should still be recognized.

 

Not surprisingly, almost any scenario involving military conflict between the US and North Korea would result in a major hit to the world economy, and the Asian economies in particular.  The degree to which the market plunges and the period of time before it recovers would be determined by the extent to which the  war is contained. It is therefore critical that in the event of conflict, the US work closely with China, South Korea and even Russia to carry out a coordinated and effective effort against North Korea.  The US must acknowledge that these countries also have a stake in the geopolitical fallout from any change to the status quo, and will actively defend their interests in the region. For China, North Korea has served as an important buffer to the American-allied democracies of South Korea and Japan.  The Chinese government will do everything they can to ensure the preservation of this buffer, evidenced by its history of tacit support for the Kim regime over the years.  It is a scenario where the US fails to work with China that would result in the worst most protracted declines for stocks and economic output.   Therefore, if the USA is forced to engage North Korea militarily, bringing China into the fold will be essential to the success of the offensive itself, but more importantly for the period after.

 

Any military war in the region would have major global economic implications because it is highly unlikely that South Korea would come away unscathed. World markets would suffer because of South Korea’s integral role in export markets today.  As the world’s sixth largest exporter of intermediate goods (semi-finished goods), many nations and companies depend on South Korea for technological components like liquid crystal displays (40% market share) and semi conductors (17% market share).  South Korea is also one of the world’s biggest ship builders and home to many significant multinational corporations (Samsung, Hyundai are just two that come to mind).  Generally the first way that wars are reflected in our daily lives, and investments, is through massive inflation as instant shortages of product produced by a war-afflicted nation will tank exports, resulting in a hit to the global supply chain. Further, governments often print money in order to finance military operations during wartime leading to even higher levels of inflation. It is therefore safe to say that in the short term, the impact of any military conflict will be extremely negative.

 

Major disruption to the South Korean economy (2% of world GDP) would be compounded by economic uncertainty in the United States.  Military intervention has proven an extremely costly business for the USA in recent history.  The Iraq War has cost Americans approximately $1 trillion and there is very little to show for the money spent.  With US debt hovering around 75% of its GDP, fighting a war overseas might prove to be an economic catastrophe.  And as discussed, the negative economic long term effects of a conflict with North Korea would largely be based on the extent to which the USA and China might cooperate in the aftermath.

 

But what if the military option is just a distraction while other sinister destruction is actually planned behind the scenes? Cyber wars of any type do not have precedent.  It is hard to forecast what their impact would be, given we have no way of knowing just what might be attacked. However anything dealing with basic infrastructure (financial institutions, water/power utilities, etc.) would of course have devastating effects on the economy, and perhaps even human lives. The art of war dictates that one should apply their greatest strengths to the element of surprise as well as to attack where the enemy is most vulnerable. With that in mind, we would be remiss not to consider the distinct possibility of a non-traditional form of attack. It is important to point out that North Korea’s internet is closed to foreigners, routinely monitored and limited in deployment to industry and institutions. By contrast, the US web is wide open and poorly defended against cyber attacks. It seems likely that this is where the next war will begin.  History has shown that we should always prepare for the unexpected regardless of the mainstream narrative. The most devastating effects always come when one is unprepared.

 

To conclude, virtually any type of serious conflict would have negative consequences for markets.  It is therefore somewhat concerning that markets in general have never been more complacent. Markets are priced to a point where no bad news of any type is expected. This is completely unrealistic. To reiterate, although tensions are high, a military conflict (nuclear or otherwise) with North Korea is still unlikely and avoidable.  But it isn’t impossible.  Given the potentially disastrous economic effects of a war on the Korean Peninsula, one cannot stick one’s head in the sand and ignore the seemingly inconceivable. Likewise, we must remain open to the possibility that there are other types of wars that can be fought which can generate a level of damage that is not predictable.  We hope that cooler heads will prevail, however we strongly recommend against complacency as that has never served anybody well when dealing with external shocks.  Hope is not a strategy.

 

The Summerhill Team

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