As tensions escalate between global superpower the United States and rogue state North Korea, the world is confronting the imminent threat of nuclear war and investors face the prospect of extreme volatility across global share markets.

While North Korea has long flouted international sanctions by pursuing its nuclear weapons program, its recent provocative nuclear and missile tests, coupled with the unpredictable nature of the new Trump administration, have heightened fears of a military conflict in the region.

The leaders of each nation have adopted an increasingly aggressive stance, with US Vice-President Mike Pence declaring his country’s preparedness to take military action “that could ignite a full-blown war”. North Korea has used similarly unequivocal language expressing its willingness to go to war in response to any act of US aggression, according to a BBC report.

The situation appears particularly perilous due to the nature of the personalities involved and President Trump’s apparent preference for pre-emptive and decisive military force demonstrated by recent missile strikes on Syria.

The situation remains fragile with the potential for inflammatory words or actions (perceived or actual) by either the US or North Korea to lead the other to believe they are planning an imminent attack. This could result in pre-emptive military action by either nation.

Events uncertain

A nuclear conflict would undoubtedly be a significant negative for the global economy and equity markets alike.

But as the current threat to world peace is unprecedented in modern times, it is very difficult to predict how events may unfold.

Analysts are postulating a range of possibilities including nuclear attacks on Japan and South Korea (Australia’s second- and fourth-largest trading partners, respectively) and the mass migration of North Koreans to China.

Another possibility is a breakdown in trade relations between various nations (including China) leading to a sustained, worldwide economic downturn.

Up to this point, equity markets seem to have considered the nuclear capability of the errant North Korean regime to be a largely latent threat.

While in recent weeks the escalation of hostilities between the US and North Korea has weighed on investor sentiment to some extent, markets have been subdued in their response and so far ruled out the prospect of nuclear war.

Markets desensitised

The threat of conflict has been building for some time with North Korea conducting two nuclear tests and 24 ballistic missile tests last year.

The rogue state has also claimed it has developed an intercontinental nuclear missile to reach the US.

Despite the grave nature of these developments, markets in the US have pushed to new highs in recent months. In Australia, the government’s persistent concerns of a military outcome on the Korean Peninsula have failed to alarm investors.

It seems investors have become desensitised to geo-political risks as various events that threaten the financial stability of global markets, including terrorist attacks, become increasingly common.

In the post-9/11 world, investors have evidently developed resilience in the face of such events with markets quickly and sharply rebounding after initially posting steep falls.

In our view, had the current North Korean crisis occurred 15-plus years ago, we would now be seeing a very negative and prolonged market reaction.

Serious threat

Compared with other events that have threatened the stability of financial markets (such as the invasion of Iraq or last year’s shock Brexit vote), the current threat is more serious and investors should not underestimate the risk of a war.

In such an event, investors should brace for high levels of volatility in the short term across global equity markets. Beyond this immediate and negative impact on markets, it is uncertain how events would transpire.

Although the true intentions and capabilities of the North Korean regime remain opaque, it appears committed to its nuclear weapons program and conducting further nuclear and missile tests.

Investors should closely monitor the situation given the potential for current hostilities to deteriorate further within a short timeframe.

Chris Stott is chief investment officer at Wilson Asset Management.

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