Hedging smart amid geopolitical risk

United States President Donald Trump warned that "all options are on the table" after North Korea launched a missile over Japan, sparking a sell-off in risk assets on Aug 29. Safe-haven assets such as gold and the yen rose, while equities fell, with the Europe Stoxx 600 losing more than 1 per cent.

But, as with previous escalations in tension over North Korea, this latest event should have a relatively short-lived impact.

Pyongyang's missile tests this year have corresponded to an average single-day decline in the Kospi of just 0.1 per cent, while declines in the index of 1 per cent or more have been as equally likely to stem from global tech weakness as from North Korea tensions.

Our base case remains for a diplomatic solution. The timing of the test, towards the tail end of joint US-South Korea military exercises, as well as the increased calls for diplomatic talks, suggests posturing rather than intensification. The missile's trajectory over Japan is also less likely to provoke a US military response than a test launch from North Korea towards Guam would.

While tensions have clearly escalated, this doesn't mean that military conflict is imminent. Investors who retreat from markets at a time of improving global earnings and growth could miss out on further market gains.

Instead, rising geopolitical tensions should make for a stronger focus on diversification and smart trades - those that would perform well, regardless of the geopolitical outcomes on the Korean peninsula.

The North Korean regime has threatened the US and its Pacific allies with apocalyptic fury for decades.

Behind President Trump's recent "fire and fury" rhetoric is the reality that the US is unlikely to tolerate a nuclear North Korea capable of hitting the continental US with long-range ballistic missiles.

Since July, we have upgraded our risk probability of a full-scale US-North Korea military conflict to 10 to 20 per cent, from less than 10 per cent. But we remain confident that the overall risk to markets from North Korea in the next six to twelve months is low, and that a transition to our tail risk scenario remains highly improbable. The devastating consequences of war make a US military strike against North Korea an option of "last resort", in our view.

Still, we recognise the substantial downside that risk investors may face in the event of a military conflict.

Asian assets will likely sell off if it came to blows, with equities (minus 20 per cent), credit (minus 8 per cent), currencies (minus 5 to 10 per cent) and commodities (minus 10 per cent) all plunging from current levels. In particular, the USD-JPY could fall towards 102-105 as investors rush to safe-haven assets such as the yen, although this is expected to be short-lived.

Investors should be on the alert for three red flags that point to a rise in danger: increased North Korean technological readiness in their weapons programme, signs of military preparedness in the US, and moves in sanctions that strike more broadly at US-China relations.

We would review our portfolio strategy should these indicators point to a surge in the risk of military conflict but until then, we remain invested with an overweight on global equities versus bonds.

North Korea has rumbled for years and China, as well as the US, has every incentive to ensure that the current crisis is settled via conventional diplomacy, enhanced sanctions and even political subversion rather than military action.

The global economic backdrop remains positive for investors. Supported by benign monetary policies and muted inflation, the global economy is still in a synchronised upswing.

The euro zone expanded at an annual rate of 2.2 per cent in the second quarter, up from 1.9 per cent in the first, while the past quarter confirmed annual earnings growth of 12 per cent in the US and around 10 per cent in the euro zone.

Asia, meanwhile, continues to surge ahead: Real GDP growth should comfortably exceed 6 per cent this year, and the region looks set to register double-digit earnings growth, both in 2017 and in 2018.

In Asia, certain sectors and regions are positioned better than others. Chinese financials, which have lagged behind the 39 per cent MSCI China rally, should start catching up as supply-side reforms support the asset quality of banks.

New technology and Internet Chinese shares should continue to lead China's equity market even higher.

Outside of China, Indonesian and Thai shares should enjoy an earnings boost on more stable commodity prices, while Philippine and Malaysian shares could underperform.

And while we are neutral on Singapore's equity market, we believe that its property developers can benefit from rising sales as private residential prices are set to trough this year and post a low single-digit growth next year.

North Korea-US relations will remain precarious, and tensions are likely to stay elevated.

Concerned investors should maintain a well-diversified portfolio and continue to stay invested. This helps mitigate drawdowns and ensures participation in the positive environment for equities.

Additionally, select trades with three-to-six-month time horizons could offer returns, regardless of the geopolitical outcome. Our equity positions of long China versus short Taiwan and long Indonesia versus short Philippines should deliver positive performances during global risk-off periods.

Investors can also buy the US dollar versus the Australian dollar or the Singapore dollar as both economies face domestic headwinds amid a rising US dollar yield environment and tend to underperform the US dollar during risk-off conditions.

Another potential trade is a long position in silver or gold versus industrial metals.

In short, we remain comfortable with our preference for risk assets and remain overweight on global equities.

North Korea's testing of its intercontinental ballistic missile capability has increased the probability of military conflict, but war is not imminent. A move to safe-haven assets could prove costly, and concerned investors should look to portfolio diversification and smart hedging as effective strategies.

•The writer is the Asia-Pacific regional head at the chief investment office of UBS Wealth Management.

A version of this article appeared in the print edition of The Straits Times on September 04, 2017, with the headline 'Hedging smart amid geopolitical risk'. Print Edition | Subscribe