One of the recurring themes of broad market complacency has been traders' unwillingness to price in, or even react, to surging geopolitical risk. This morning, Goldman picks up on this conundrum, with a note by Charles Himmelberg in which Goldman's chief credit strategist expresses his dismay at market reactions to surging political risks and threats, and focusing on the latest events in North Korea, writes that "our sense is that investors have grown comfortable with the view that geopolitical tensions invariably result in diplomatic talks, in which case the right trade is to buy any dips. The result is a market psychology that is relatively resistant to the pricing of geopolitical risk." Taking a step back, this is how he summarizes the latest market events: North Korea risk continues to rise. A series of ICBM launches in recent weeks prompted the UN to pass new sanctions last weekend, prompting sharply worded statements between North Korea and the US over the past few days. Yesterday Japan elevated its North Korea threat level and news outlets reported that the US Defense Intelligence Agency believes North Korea has already developed missile-ready nuclear warheads. Markets have been pricing a diplomatic outcome, although the escalating war of words over the past 24 hours between the US and North Korea has caused a modest repricing of Korean risk assets and global safe havens.
That said, the KOSPI remains near all-time highs and the pricing of tail risk in Korean derivative markets still shows little sign of concern.
To be sure, this is not the first time Goldman has discussed just how inert to political shocks the market has become. Back in May, the firm argued that "geopolitical tensions on the Korean Peninsula were “rising, not pricing”. Since then, the risks have continued to mount, while markets appear to have taken the tensions in their stride. According to a new Pentagon assessment, North Korea will be able to launch a reliable, nuclear-equipped intercontinental ballistic missile as early as next year. In response to the new UN sanctions this weekend, North Korea’s state-run news agency accused the US of "trying to drive the situation of the Korean Peninsula to the brink of nuclear war" and vowed to “make the US pay dearly for all the heinous crimes it commits against the state and people of this country.”
In the biggest event of an otherwise quiet day, President Trump continued the war of words yesterday, stating that aggression would be met with “fire and fury like the world has never seen.” Also yesterday, Japan upgraded its official assessment of the threat from North Korea, cautioning that the threat had entered a “new stage” and that North Korea may have already acquired the ability to weaponize nuclear warheads.
And, as Himmelberg adds, while overnight markets began to take notice after North Korea made comments regarding plans to attack Guam, the KOSPI stock index still remains is just 4% from the all-time high it reached in May.
For decades, complacency has been the "right trade” when it comes to North Korea. More often than not, market participants have been rewarded for fading negative price moves rather than hedging them. Our sense is that investors have grown comfortable with the view that geopolitical tensions invariably result in diplomatic talks, in which case the right trade is to buy any dips. The result is a market psychology that is relatively resistant to the pricing of geopolitical risk.
Korean assets have seen a modest 'risk off' over the past two weeks, but this most likely reflects a modest cooling in global growth data. Since July 24 and prior to the last 24 hours, the trade-weighted Won had depreciated 1% while the KOSPI had declined 2.5%. These moves are consistent with the recent weakening of our Global Current Activity Indicator (CAI), which moderated to 4.3% in July from 4.9% in June. The export-intensive Korean economy tends to track the global demand environment closely.
In addition, Korean markets might have been affected by recent policy initiatives of the new pro-labor government, including tax hikes and a historical minimum wage hike. But since the geopolitical risks on the Korean peninsula are more tail events than modal events, we prefer to look at derivative markets for evidence of market pricing.
Derivative markets in equities do not show much sign of geopolitical tensions. In our May report, we found that for the KOSPI both the 25-delta one-month implied volatility and the 25-delta put-call skew mirrored the vol pattern in European and US equity markets, which suggested that the French elections, not Korean tensions, were driving vol. As Exhibit 1 shows, KOSPI skew increased slightly yesterday after gradual rises in recent weeks (consistent with the delta one move we noted above), but has only now caught up to the levels of skew seen in European and US equity markets.
Exhibit 1: KOSPI vol has risen over the past 24 hours.
KOSPI, Euro Stoxx 50, and S&P 500 skew (one-month 25-delta puts minus one-month 25-delta calls). Data as of 3PM HKT, Aug 9...
FX-implied volatility, on the other hand, appeared to hint at some lingering anxiety when we last looked in May. The clearest evidence of geopolitical concern we found was in KRW/USD implied skews, which rose in April amid the arrival of US carriers in the region, and remained near three-year highs. As Exhibit 2 shows, KRW skew rose on Aug 9 after falling steadily in the intervening months and is now back to where it was in the early spring when US-North Korea tensions began to escalate. The steady decline (until end-July) suggests that the few modest concerns we documented in Korean derivatives markets back in May seem to have moderated even as geopolitical concerns have continued to grow, suggesting that markets were discounting the risks of military action or tougher bilateral sanctions....