North Korea U.S. Summit: What Is Different This Time?

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1 WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS Bobby Zheng, CFA Investment Strategy Analyst May 1, 2018 North Korea U.S. Summit: What Is Different This Time? Key takeaways» The recent inter-korean summit and the upcoming meeting between President Trump and North Korean leader Kim Jong-un may present some volatility risks for financial markets.» While we do not anticipate a breakthrough denuclearization deal to be reached at the U.S. North Korea summit, lesser concessions for future discussions on the topic could be positive for political stability on the Korean peninsula. What it may mean for investors» In our view, investors should not attempt to position a portfolio ahead of a particular geopolitical event, since this can be costly and possibly counterproductive. To help mitigate geopolitical risks in the U.S. and abroad, our strongest conviction advice is for long-term investors to develop and adhere to a globally diversified investment plan. The third inter-korean summit attended by South Korea s president Moon Jae-in and North Korea s leader Kim Jong-un convened on April 27 at the Peace House, located just south of the military demarcation line in South Korea. This event set the stage for the much anticipated North Korea United States summit later in May. After a year of threats and challenges in 2017, the leaders of North Korea, South Korea, and the United States recently have espoused a more optimistic view that a permanent settlement removing nuclear weapons from the Korean peninsula could be possible. Yet, there is room for disappointment and financial-market volatility if these meetings fall short of that goal. This report highlights a few important factors for investors to watch to gain additional insights regarding political stability on the Korean peninsula. What is different this time? North Korea s nuclear program advancement North Korea withdrew from the Nuclear Nonproliferation Treaty in Since then, the U.S. has offered security guarantees, normalization of relations, and economic and humanitarian aid as incentives to denuclearize. Yet, the North Korean regime has steadily pursued its nuclear ambitions, including a recent acceleration notably, larger nuclear tests and intercontinental ballistic missile (ICBM) trials Wells Fargo Investment Institute. All rights reserved. Page 1 of 6

2 International sanctions with China s support China s exports of energy and other raw materials to North Korea allow Beijing to support its neighbor as a strategic buffer between China and U.S. ally South Korea. However, China punished North Korea last year by reducing key exports of energy, after North Korea s missile tests threatened regional stability. Chinese customs data (Chart 1) indicate that China s exports to North Korea have hit a new low. As the sanctions undercut North Korea s struggling economy, Pyongyang faces a rising cost for continuing its nuclear weapons program. Chart 1: Chinese exports to North Korea year-over-year change (Three-month moving average) Sources: Wells Fargo Investment Institute, China Customs General Administration, Bloomberg, Data as of February 28, What related events can affect financial-market volatility? North Korea North Korea ultimately wants to reunify the Korean peninsula under its communist party. In the short term, Pyongyang wants the nearly 24,000 U.S. military personnel to leave the peninsula, and for the U.S. and South Korea to cease military exercises. In exchange, Pyongyang could offer to abandon or scale back its nuclear program. Yet, North Korean leadership has had a diminishing commitment to this option in past talks, and Pyongyang would have even more to give up at this point. It is possible to interpret North Korea s posture in past negotiations as a strategic ploy to buy time for its nuclear weapons program. China China also prefers a communist regime on its border and a smaller U.S. military presence on the Korean peninsula. Additionally, Beijing wants to be involved in any resolution of the North Korean crisis to strengthen its strategic interest in the region. This was clear from Beijing s invitation to Kim Jong-un for a state visit in March his first since taking power more than six years ago Wells Fargo Investment Institute. All rights reserved. Page 2 of 6

3 U.S. and South Korea Both countries want a detailed denuclearization deal but have no clear military options to use as leverage. Potential deterrent activities, such as air strikes, are unlikely to wipe out North Korea s nuclear facilities and are becoming riskier, given recent advancements in North Korea s nuclear development program. Additionally, any hint of U.S. preemptive action against North Korea could be met quickly by a Chinese military takeover of North Korea. We make two observations from this analysis. First, a new war is possible, but we believe that it is improbable. China has made no secret of the fact that it has military units ready to potentially take over North Korea, if Kim Jong-un s government were at risk of falling. Second, some concessions are likely at the anticipated leadership summit in late May or early June. The most important concession of North Korean denuclearization (in return for a peace treaty and U.S. troop withdrawal) may take longer. However, we would not be surprised to see lesser concessions. In fact, Kim Jong-un s April 20 announcement that North Korea would no longer test nuclear weapons and intercontinental ballistic missiles can be interpreted as Pyongyang s willingness to make some mutual agreements. These could include suspension of the North Korean missile program in exchange for U.S. humanitarian aid and reduction of economic sanctions; liaison offices in Pyongyang and Washington, D.C.; and ongoing discussions about denuclearization and a peace treaty (to replace the 1953 armistice). Investor implications Even these lesser concessions could be positive for global financial markets, but we caution that enthusiasm could be modest and markets may take a wait-and-see approach. The longer-term goal of North Korean denuclearization could take a decade of international inspections to verify that testing has ended and that weapons systems are destroyed or disassembled. In the meantime, investors should monitor ongoing U.S. North Korean diplomatic negotiations as a necessary condition for further progress toward more market-significant results. Because there are typically simultaneous political risks around the world, sometimes with opposite portfolio implications, positioning a portfolio ahead of a particular geopolitical event can be costly and possibly counterproductive. For example, a trade war may favor U.S. small and midsize companies, but markets in noncombatant countries could outperform in a military war between the U.S. and North Korea. While there are geopolitical risks in the U.S. and elsewhere in the world, our strongest conviction is that long-term investors should develop and adhere to a globally diversified investment plan. Diversification doesn t hedge against any particular geopolitical risk, because the probability and magnitude are difficult to predict. However, diversification provides the investor some flexibility to forego possibly complex and expensive hedges of a particular risk that may not be realized. In addition, our tactical advice is designed to raise or lower risk in portfolios as opportunities and risks arise from the economy. Our current tactical positioning anticipates limited market disruption from the upcoming U.S. North Korean meeting, solid economic growth (particularly in the Pacific region), and low inflation globally in the next 12 months. This should allow global equity markets to continue to climb higher. We favor U.S. equity markets over international equity markets in the near term 2018 Wells Fargo Investment Institute. All rights reserved. Page 3 of 6

4 as U.S. companies continue to benefit from domestic tax policy changes and relatively high consumer and business confidence. We do not anticipate that these positive domestic market conditions will be overshadowed by the upcoming U.S. North Korean meeting and suggest that investors maintain their full target allocations to global equities. Within U.S. equities, we favor the equity sectors that should outperform under stronger economic and earnings growth, including the Consumer Discretionary, Industrials, and Financials sectors. We have an unfavorable view of those sectors that are more interest-rate sensitive, particularly Utilities and Consumer Staples. However, we currently favor real estate investment trusts (REITs), which may benefit from relatively high yield and capital appreciation potential from rising real estate prices Wells Fargo Investment Institute. All rights reserved. Page 4 of 6

5 Economic Calendar Date Report Estimate Previous 5/1/2018 Markit US Manufacturing PMI /1/2018 Construction Spending MoM 0.30% 0.10% 5/1/2018 ISM Manufacturing /1/2018 ISM Employment /1/2018 ISM Prices Paid /1/2018 ISM New Orders /1/2018 Wards Domestic Vehicle Sales m 5/1/2018 Wards Total Vehicle Sales 17.20m 17.40m 5/2/2018 MBA Mortgage Applications % 5/2/2018 ADP Employment Change 204k 241k 5/2/2018 FOMC Rate Decision (Upper Bound) 1.75% 1.75% 5/2/2018 FOMC Rate Decision (Lower Bound) 1.50% 1.50% 5/3/2018 Challenger Job Cuts YoY % 5/3/2018 Nonfarm Productivity 1.00% 0.00% 5/3/2018 Initial Jobless Claims /3/2018 Unit Labor Costs 3.10% 2.50% 5/3/2018 Continuing Claims /3/2018 Trade Balance -$56.0b -$57.6b 5/3/2018 Bloomberg Consumer Comfort /3/2018 Markit US Services PMI /3/2018 Markit US Composite PMI /3/2018 ISM Non-Manf. Composite /3/2018 Durable Goods Orders /3/2018 Durables Ex Transportation /3/2018 Cap Goods Orders Nondef Ex Air /3/2018 Cap Goods Ship Nondef Ex Air /3/2018 Factory Orders 0.90% 1.20% 5/3/2018 Factory Orders Ex Trans % 5/4/2018 Change in Nonfarm Payrolls 185k 103k 5/4/2018 Two-Month Payroll Net Revision k 5/4/2018 Change in Private Payrolls 190k 102k 5/4/2018 Change in Manufact. Payrolls 19k 22k 5/4/2018 Unemployment Rate 4.00% 4.10% 5/4/2018 Underemployment Rate % 5/4/2018 Average Hourly Earnings MoM 0.20% 0.30% 5/4/2018 Average Hourly Earnings YoY % 5/4/2018 Average Weekly Hours All Employees /4/2018 Labor Force Participation Rate % 5/7/2018 Consumer Credit -- $10.601b 5/7/2018 Mortgage Delinquencies % 5/7/2018 MBA Mortgage Foreclosures % Source: Bloomberg as of April 25, Wells Fargo Investment Institute. All rights reserved. Page 5 of 6

6 Risk Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Diversification cannot eliminate the risk of fluctuating prices and uncertain returns and does not guarantee profit or protect against loss in declining markets. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR Wells Fargo Investment Institute. All rights reserved. Page 6 of 6