North Korea Leader Kim Jong Un. Source: Daily Express

Last month North Korea launched an intercontinental ballistic missile that it said was capable of hitting the heart of the United States:

The Trump administration on Tuesday confirmed North Korea’s claim that it had launched an intercontinental ballistic missile, and it told Pyongyang that the United States would use “the full range of capabilities at our disposal against the growing threat.”

… The North’s state-run Korean Central News Agency said its new intercontinental ballistic missile, the Hwasong-14, was capable of hitting the “heart of the United States” with “large heavy nuclear warheads.” The launch, according to the agency, successfully tested the functions of the missile’s two propulsive stages and the warhead’s ability to endure the intense heat and vibrations as it entered the earth’s atmosphere.

Prior to the July launch North Korea has tested at least twelve other missiles with short to intermediate range capabilities. The method behind the madness of North Korea’s Kim Jong Un seems to be constantly evolving. Some suggested that missile tests conducted in February were designed to test the preparedness of the new Trump administration. In early March South Korea and the U.S. kicked off their annual Foal Eagle Exercise – a large-scale military training designed to improve combat preparedness of U.S. and South Korean forces on the peninsula. North Korea also threatened to conduct more missile tests in response to Foal Eagle training exercises.

Impact On Financial Markets

In an act of bravado or an attempt to demonstrate the United States’ combat preparedness, President Trump promised to meet any North Korea threat with fire and fury:

The US president on Tuesday warned Pyongyang that he would meet North Korea’s threats “with fire and fury like the world has never seen”. North Korea responded with hints that it might attack the US territory of Guam in the Pacific, in turn leading to Mr Trump to talk about the US nuclear arsenal. “My first order as president was to renovate and modernise our nuclear arsenal. It is now far stronger and more powerful than ever before,” he tweeted on Wednesday morning. “Hopefully we will never have to use this power, but there will never be a time that we are not the most powerful nation in the world!”

Previous missile tests or aggressive language from North Korea have not necessarily impacted financial markets. However, last week’s tete-a-tete between Trump and Kim Jong Un sent financial markets lower. The Dow Jones (DIA) ended down one percent for the week. The NASDAQ (NDAQ) was down as much as three percent, but ended down two percent. The tough talk could help defense stocks long-term, however. The Aerospace & Defense ETF (ITA) fell one percent on the week. It boasts Boeing (BA), United Technologies (UTX), Lockheed Martin (LMT), and General Dynamics (GD) as its largest holdings and is up over 25% Y/Y. ITA should continue to outperform the general market if Trump’s proposal to increase military spending ever kicks in.

Financial markets do not like uncertainty and scenarios of North Korea bombing Alaska or Hawaii are never good. The likelihood of nuclear war with North Korea appears remote. In my opinion, the financial markets were looking for an excuse to sell off anyway. In early August the Dow closed above 22,000 for the first time, and has appreciated 18% Y/Y. An accommodative Fed has been supporting financial markets since the Financial Crisis of 2008/2009. That could come to an abrupt end if Fed Chairwoman Janet Yellen begins to unwind its prodigious balance sheet next quarter. A combination of Yellen and Kim Jong Un should unnerve investors.

What Does Kim Jong Un Really Want?

During the regime of Kim Jong Un’s father – Kim Jong Ill – North Korea’s missile tests were considered saber rattling. The U.S. and other countries could typically pacify Jong Ill by sending North Korea food stuffs or other supplies. However, Jong Un’s goal could be to garner the capability of striking the U.S. with a missile topped with a nuclear warhead. In Jong Un’s mind, a nuclear threat to the U.S. could potentially defend him against regime change orchestrated by the U.S.:

They want it because they believe the US will eventually try to remove Kim Jong Un from power.

But would the United States try to topple the Kim regime if North Korea could respond with a nuclear attack?

Pyongyang believes Washington wouldn’t, and that’s why the country sees nuclear weapons as the key to sparing Kim Jong Un from a fate similar to that which befell Moammar Gaddafi in Libya and Saddam Hussein in Iraq.

The threat of a U.S. attempt to remove Kim Jon Un from power could be real or imagined. Nonetheless, it could likely fuel future missile tests and attempts to improve North Korea’s nuclear capabilities. That likely portends more volatility and uncertainty for the financial markets.

Conclusion

Geopolitical tensions or potential actions from global central bankers cause volatility for financial markets and/or send markets sharply lower. I recommend that investors reduce exposure to financial markets.

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