As it began, this week appeared to be on track for another sleepy August session. However, the peace was broken as tensions between North Korea and the US rapidly escalated overnight Tuesday. Responding to North Korea’s threat of “physical” retaliation against the new UN sanctions, Donald Trump issued an extraordinary warning that any further threats from Pyongyang would be “met with fire and fury like the world has never seen”. Kim Jong Un ridiculed Trump’s warning as a “load of nonsense” and announced a detailed plan to launch missiles aimed at the waters near the coast of the US Pacific territory of Guam.
Unsurprisingly, this verbal brawl between the two leaders drove markets into “risk-off” mode on Wednesday. Investors piled into so-called “haven” assets, pushing gold to a fresh two-month high, the yield on the 10 Year Treasury to below 2.25%, and triggering a rally in the Swiss Franc off its one-month low. In turn, riskier assets suffered, but the initial market reaction was considered somewhat muted, relative to the potential severity of the threat. To illustrate this point, consider that the S&P 500 Index had been in a 90-year record low trading range of no moves bigger than 0.3% in either direction for 14 days. Arguably, it would be reasonable to expect something like an increased threat of nuclear confrontation to trigger the Index to break out of this range. However, on Wednesday the Index closed just 0.04% lower. J.P. Morgan made the point that geopolitical stress has been the norm, not the exception, for decades, and so perhaps until something happens, markets will continue to shrug off such threats.
However, Trump turned up the heat on Thursday, declaring that he may not have been “tough enough” in his earlier warning. This time, the S&P 500 ended down 1.45%, its worst day in three months. While far from seismic, the move signalled mounting market nerves. The equity sell-off continued on Friday with European markets opening around 1% lower. The VIX, a measure of volatility, hit its highest level since April, although this is still extremely low in the context of developments since The Great Financial Crash of 2008. So once again, questions are being asked as to why the market reaction has not been more pronounced. Rabobank suggest that the modest response is reflective of the extreme difficulty the market faces in pricing in the consequences of a nuclear attack.