Macro Weekly – Hold your nerve

by: Han de Jong

  • Anxiety over North Korea
  • US inflation falls marginally short of expectations…again
  • Chinese reserves continue to recover
Macro-Weekly-11-August-2017.pdf (64 KB)

Verbal exchanges between the US and North Korea have become much more aggressive recently. This raises a number of questions, such as:
• what is different now from the last couple of years?
• what can be expected?
• and what should investors do?

What’s the difference?

I do not claim to be a political scientist or an expert on North Korea, but the escalation of the tension is something I cannot ignore in my weekly commentary. It seems to me that three things have changed compared to the last couple of years. First, according to a recent full-page article in the Financial Times, economic reform in North Korea is leading to something of an economic upturn. This may have strengthened the self confidence of the leadership. Second, the international awareness of North Korea’s nuclear capabilities has been strengthened by various recent tests. And third, President Trump has a very different style and is following different tactics from his predecessor. As my colleague Didier Duret, Chief Investment Officer of ABN AMRO Private Banking, puts it: ‘The broader context is that the Trump administration has introduced a new approach to international affairs. We see a 180-degree difference from the “leading from behind” motto of previous administrations. The Trump White House is obviously more assertive and will lean on established alliances. The markets need to recognize and come to terms with this new political environment.’ I guess what Didier is saying here is: do not mistake the change in rhetoric for a change in military strategy.

Limited policy options on both sides

It is hard to say if all that makes the situation actually more dangerous. I still find it hard to imagine that North Korea would use a nuclear device. Surely, the leadership realises the rest of the world will not tolerate that and it would be the end of the current North Korean leadership. Equally, a military intervention by the US is unthinkable due to the vulnerability of Seoul. The South Korean capital is just some 50 kilometres across the North Korean border. Any military intervention on North Korean soil will surely be answered by an unstoppable attack on Seoul.

North Korean leaders have recently suggested they might attack Guam. Guam is some 3,500 kilometres away from North Korea. This may not be a completely empty threat as the North Koreans are thought to have missiles that could travel as far as double that distance. Guam is a so called “unincorporated US territory”. It has only some 200,000 inhabitants, but it also is an important military base for the US. An attack on Guam is an attack on the US army. It is hard to imagine that North Korea would actually attack the US military base on Guam. If they do it, it would certainly consist of firing some missiles. They may even fire some (conventional) missiles and deliberately miss, just to provoke the Americans and see what the reaction is. My guess is that in such a case the Chinese will be willing to use their leverage over the North Korean leadership.

Geopolitics and markets

Geopolitical developments certainly have the ability to move markets. Lasting damage to markets for risky assets is usually only done when economic fundamentals that drive financial markets in the longer term are affected. A nuclear military conflict, obviously, would affect global economic fundamentals. Even a non-nuclear conflict in which Seoul is damaged could have sustained negative effects on markets for risky assets. But any outcome short of a military conflict will only have a temporary effect on markets. And, let me repeat, we consider an actual military conflict highly unlikely. We also need to bear in mind that recent negative market action has been ‘encouraged’ by strong performance over he last 12 months, triggering profit taking. The uncertain prospect of key central banks moving towards ‘normalisation’ of monetary policy in the quarters ahead is perhaps another reason for some investors to take money off the table.

The best defence against the effects of geopolitical tensions on an investment portfolio are diversification, strong nerves and patience.

Another low US inflation number

US inflation has surprised on the downside for several months. July was no exception. Headline inflation amounted to 0.1% mom and 1.7% yoy. The latter was up marginally from 1.7% in June, but it was still a tad lower than expected. Core inflation was also 0.1% mom and 1.7% yoy, unchanged from June. A big part of core inflation consists of the cost of shelter. This is a somewhat debatable element as the high weight of ‘imputed rent’ is based on the assumption that homeowners are also hit by an increase in rents, which they are obviously not. There are other qualifications to make as well, but I do not want to dwell on them here. If the cost of shelter is excluded from the core inflation rate, the yoy rate of the remaining basket only amounted to 0.6% while the 3-month moving average annualised rate was a mere 0.28%.

It would seem that the trend of weak inflation is continuing, despite decent enough overall economic growth. This will put further pressure on the Federal Reserve to reconsider their projections for the path of official interest rates. The most recent consensus projections by the FOMC are that the committee will hike one more time this year and three times next year. Futures markets appear to be suggesting that a rate hike before Christmas is possible but not certain and that the Fed will hike only one time next year at most. Our view has been in between these positions for some time. That is not changing now, but the risks to inflation forecasts are clearly skewed to the downside and so are the risks to our Fed call.

Chinese reserves rise again

Recent days have been light on important macro data. Perhaps it is worth mentioning that Chinese FX reserves increased by USD 24 bn in July to USD 3,080 bn. It was the sixth consecutive monthly increase. Before that, FX reserves had fallen in a straight line from June 2014 to February 2017 for a total drop of USD almost USD 1,000 bn. This drop reflected outflows and contributed to nervousness in financial markets at times. The more recent trend of modest growth is reassuring for financial markets.