QVM Clients:
I have received some calls asking whether and how to prepare portfolios for possible war with North Korea. Whether a war is likely is beyond my capacity to respond, but whether portfolios should be prepared for extreme market conditions resulting from any number of catastrophic situations is something on which I will comment.
Let me state right out of the gate, preparing a portfolio for a generalized Black Swan or catastrophic event is prudent. We should all have a protective component of our portfolios, all of the time – more for the older of us and less for the younger of us, based in great part on the time horizon before calling on the portfolio for withdrawals. However, tailoring a portfolio against a specific catastrophic event is generally not prudent, unless you are dead certain it will happen. And in that case, everybody else is probably dead certain too, and the event would already be substantially priced into the market.
So, while I can suggest a portfolio specifically tailored for a war between the USA and North Korea, I do not recommend implementing it. Such a portfolio would not represent your long-term strategy (which should include a protective component), and if that specific event did not materialize you could find yourself way off course.
With that caveat, let’s think about what a portfolio specifically tailored for an anticipated war between the USA and North Korea.
Don’t think me cold-hearted in discussing portfolio war preparation, because the tragic death of 100’s of thousands of people, including thousands of US troops stationed in South Korea would be horrific almost beyond imagination. According to former US Defense Secretary Cohen today, North Korea could lay waste to Seoul South Korea in about 1 minute from the 10,000 artillery pieces trained on that city at all times. But some of you asked about portfolios, not human tragedy. I am not inclined to plunge into portfolio war preparation, unless an individual should prevail upon me to do so, but I am prepared to say what portfolio might fare better in the event of such a war.
So whether it is war with North Korea, or worldwide plague, or hackers shutting down our electrical grid and somehow disabling our Internet for a prolonged period; the assets that provide clear defensive protection are:
• Cash (insured bank accounts or Treasury money market funds)
• Gold (proxy: GLD (NYSE:GLD))
• Treasury bonds (proxy: Vanguard Intermediate-Term Government Bond (NASDAQ:VGIT)).
Holding any of these three assets creates a current drag on portfolio income, and with the possible exception of gold, a drag on total return. Any form of protection (like insurance) has a cost, and that cost is a lower long-term total return than a flat-out equity market exposure. Except for investors with a very long time horizon before entering the withdrawal stage, some level of cash and bonds is appropriate in any event
Now for the specific war preparation portfolio, keep these index weights in mind, which will help interpret the allocation suggestions below:
- South Korea is almost 15% of the Emerging Markets index followed by iShares; but 0% of the index followed by Vanguard
- South Korea is almost 5% of the non-US Developed Markets index followed by Vanguard; but 0% of the index followed by iShares
- China is about 29% of Emerging Markets indexes
- Taiwan is about 16% of Emerging Markets indexes
- Hong Kong is about 3% of non-US Developed Markets indexes
- Japan is about 21% to 23% of non-US Developed Markets indexes
- Apple (NASDAQ:AAPL) is about 4% of the S&P 500 and about 5% of the Dow Jones Industrials
Changes one might consider (excluding shorting and options) to specifically prepare for possible war with North Korea are:
- Above target cash
- Target or above target level gold (proxy: GLD)
- Above target intermediate-Treasuries (proxy: VGIT)
- Add defense industry exposure (proxy: iShares US Aerospace & Defense (NYSE:ITA))
- Below target Emerging Markets allocation – to reduce China, Taiwan, Hong Kong and South Korea Exposure
- Within reduced diversified Emerging Markets allocation; Hold Vanguard FTSE Emerging Markets (NYSE:VWO) not EEM – to eliminated South Korea Exposure
- Within non-US Developed Markets exposure, hold EFA not VEA – to reduce South Korea Exposure
- Possibly replace diversified non-US Developed Markets funds with Europe funds (Vanguard FTSE Europe (NYSE:VGK)) – to reduce Japan exposure (proxy: iShares MSCI Japan (NYSE:EWJ))
- Reduce broadly diversified US stock holdings (proxy: SPY (NYSE:SPY)) beyond lowered target levels, and rebuild to lowered target levels with sector funds, not including technology sector (proxy: Technology Select Sector SPDR (NYSE:XLK))
- Sell single stock Apple holdings (AAPL).
Note, there may be significant non-recoverable tax costs to such a portfolio reconfiguration in regular taxable accounts. That would need to be evaluated in terms of each investor’s embedded gains, and how much of which assets are held in tax deferred or tax-exempt accounts, as well as other aspects of the investor’s general tax situation.
Why sell Apple or reduce technology sector exposure? Because, South Korea (think Samsung (KS:005930)) is a key part of the technology supply chain (including parts for iPhones). It could take a couple of years to build replacement chip foundries to supply the needed chips for Apple, unless they could find non-Asia suppliers.
Think of the war a step farther out. China decides not to fight the USA on behalf of North Korea, but does decide the war is the perfect time to invade Taiwan to reclaim it. The USA might well be unprepared to defend Taiwan while fighting North Korea, and might accept the invasion of Taiwan in exchange for China not involving itself in the North Korea conflict. Such an invasion could further damage the technology supply chain. Then, of course, Vladimir might decide to take the rest of the Ukraine or some other land grab, which would be very hard on the Europe stock markets.
What happens after the early war stages is unknowable, but as past wars have shown, the world rebuilds, and capital continues to work. So be prepared to restore equity allocation once hostilities are clearly over and stock markets begin to recover.
There would, of course, be no option to do those things to the portfolio once a shooting war opened up, as the pricing adjustments would be near instantaneous. For myself, I am not making such drastic single scenario preparations, but rather holding some level of generally protective assets along with a diversified global equity exposure. That is what I suggest to you.
This is a quite unpleasant topic to contemplate, but to make sure we’re always thinking, this is what we can fathom at the moment, as preparation for first order effects. Where second and third order effects go, is beyond pure speculation.
[securities mentioned in this letter: GLD, VGIT, ITA, VWO, EEM, VEA, EFA, VGK, SPY, EWJ, XLK, AAPL]