North Korea heightened tensions, heightened market risks

Tensions in East Asia, stemming from the Korean peninsula, have escalated, with much of the world viewing North Korea’s nuclear program and missile tests as direct provocations to the delicate equilibrium of the region.

Some evidence now suggests that Pyongyang’s nuclear capabilities are more advanced than many experts had thought, which has prompted hardening rhetoric from key actors on both sides of the Pacific.

Developments have left China and the United States struggling to adapt to a new reality, which has forced both countries to begin a rapid adjustment in policy toward North Korea. Previous policy goals—such as the denuclearization of North Korea—now seem less viable, and the current situation is fraught with miscalculation risks.

With myriad strategic interests at play, there are a number of scenarios that could surface in the weeks ahead. These range from a continuation of the current cold war to a preemptive strike by either the United States or North Korea. Our scenario analysis points to five ways the situation could play out, and we offer a glimpse of the potential implications of each one.

We view this scenario as similar to the cycle we’ve witnessed over the past decade, but with an elevated level of tension. In this case, we would expect continued missile testing, military exercises, and heated verbal exchanges, leading to greater global strains, but not to the point of prompting conventional or nuclear warfare. Economic relations between the United States and China could become increasingly vulnerable over time if tensions fester and give rise to trade restrictions between the two countries.

If the audacity of North Korea’s missile testing increases, and the United States responds by bolstering its military presence in the region, the potential for misunderstandings, miscalculations, and unintended consequences rises substantially. An error in judgment on either side could result in accidental warfare with immeasurable costs. This scenario would be catastrophic for North Korea’s economy, significantly negative for South Korea, and negative for the rest of the world, too. The risk premium across markets would rise amid a global flight to safe-haven assets.

If the Chinese government ultimately concludes that the threat of war and severe economic disruption are not worth the benefits of maintaining North Korea as a buffer state, then China may conclude it’s in its best interest to ramp up the pressure on Pyongyang: In this case, China's options include eliminating all trade and capital flows, closing its border, and restricting its airspace. China could then work toward North Korean regime change on its own terms, rather than witness its neighbor’s unruly collapse. But this bold scenario remains highly improbably, as the status quo seems to better serve China’s strategic interests. Plus, China likely lacks the ability to enact an orderly North Korean regime change.

Similar to the 2015 nuclear deal with Iran, North Korea just might agree to a sustained effort to disarm in exchange for significant economic concessions and assurances of regime continuity. Constraints to such an outcome include a lack of trust on both sides and the U.S. administration’s extreme reluctance to reward what it views as bad behavior. Relative to other possibilities as we see them, the economic implications of this unlikely scenario could be among the most positive for the whole of the Korean peninsula and the wider world.

If either country was to fear an imminent attack from the other, a preemptive strike could be launched—conventional or nuclear. For North Korea, it would be self-destructive, in all likelihood; for the United States, it would be morally indefensible and militarily problematic. Aside from the humanitarian and geopolitical consequences, economic implications would be catastrophic for South Korea and significantly negative for China and the United States.

We view scenario 1 as by far the most likely outcome. We expect more oscillation between provocation and de-escalation in the weeks and months ahead, but we don’t believe the situation will devolve into warfare. This view is based on the United States following a policy of acceptance and deterrence, similar to the approach it adopted after China developed similar capabilities under Mao Zedong.

The risks of a miscalculation resulting in warfare can’t be ruled out, but the U.S. and North Korean governments have a history of showing restraint during crises. Recent behavior—beyond the acerbic rhetoric—on both sides suggests similar restraint is likely to prevail. A China-led intervention remains a possibility, but we deem it highly improbable since the status quo better serves China’s strategic interests. Each scenario involving warfare has significant negative economic consequences in East Asia and the world’s other regions as well.

While no one can know how the current standoff will end, investors need to be aware of the risks. We see the probability of armed conflict as relatively low—but it’s not zero.