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Banking & Finance

The view from the market on Kim Jong Un

Prospect of further escalation supports defensive stance on South Korean assets

For the first time since Kim Jong Un took over leadership of his hermit North Korean kingdom five years ago, investors in the South are finally showing signs of worry.

The alarm, which saw the benchmark Kospi index fall 3.2% during the week of Aug. 7, started with U.S. President Donald Trump's outburst that the world can expect "fire and fury" if North Korea continues to threaten his country. Trump raised the rhetoric a few days later by declaring, "Military solutions are now fully in place, locked and loaded, should North Korea act unwisely." Pyongyang responded by announcing a plan to fire missiles toward Guam, a Pacific island territory of the U.S. home to two important military bases.

With an unconventional U.S. president at the helm with little regard for political protocol, Kim Jong Un has an ideal partner in intensifying the world's perception of risk. For the past decade, investors have ignored Pyongyang's saber-rattling, assuming that China and the rest of the world would coordinate a calm, diplomatic response to any scenario. Stock and currency traders have used the occasion of North Korean provocations as buying opportunities.

The events of recent weeks have however highlighted the disturbing similarity in negotiating tactics between Trump and Kim whereby impulsive threats and drum-beating seem to be part of gaining an edge over opponents. The combination of nascent North Korean nuclear ICBMs and the new American leader have changed risk dynamics, presenting Kim with a new chance to achieve his ultimate goal of economic and political security.

During the rule of Kim Jong Il, Kim Jong Un's father, North Korea consistently demanded direct bilateral contact with the U.S. But since then-president George W. Bush's declaration that North Korea, Iraq and Iran constituted an "axis of evil" in 2002, the U.S. has insisted on dealing with Pyongyang via multilateral talks involving China, Russia, South Korea and Japan.

For Kim Jong Un, bilateral talks with the U.S. are a necessary precursor to being recognized as a legitimate sovereign state rather than a rogue nation under Chinese sponsorship. The current war of words between Kim and Trump actually equates to a form of bilateral talks, albeit a chaotic one.

The ultimate goal of Kim and his generals is not Armageddon but open-ended political security. Kim and his father have thus committed enormous sacrifices of economic and human resources for the past 20 years to attain nuclear and intercontinental ballistic missile capability.

The latest U.N. economic sanctions will do very little to deter Kim's once-in-a-lifetime opportunity to secure economic and political guarantees for himself and his regime. The U.S. and the U.N. have critically overestimated the power of China and economic sanctions. Increasingly credible data is emerging that the North Korean economy is improving at a rapid rate, driven by rising domestic trade and commerce.

A perfect pair

Trump would be ill-advised to expect Kim to adhere to a swift and permanent compromise. A volatile U.S. president who seems to disregard his intelligence advisers is an ideal counterparty for Kim in inflating global risk perceptions.

While any further escalation between Kim and Trump should fall short of war or even a major military conflict, the dangers for investors come from two unpredictable, belligerent leaders who seem to revel in shocking the world with their antagonistic styles of governing. The gap between the two governments' demands and expectations are too wide for an orderly, permanent resolution.

Financial markets should prepare for a long, drawn-out drama as there is no rush for Kim to seek a speedy resolution. North Korea has a long history of negotiating via cycles of threats and appeasements, designed to wear out its counterparties and maximize gains in the process.

The nation most vulnerable to threats and incursions is South Korea, not the U.S. In 2010, a North Korean submarine sank a Southern navy ship, killing 46 sailors. The same year, North Korea bombed a Southern island village near the maritime border, killing six civilians. Neither incursion was met with a forceful response from the U.S. or South Korea. These two events set a dangerous benchmark for further incursions of similar or greater scale.

Though Kim is not a hurry, he will want to execute his plans to leverage nuclear weapons within the four years of Trump's term to seize the opportunity offered by the unconventional U.S. president. At this juncture, though, it is hard to envisage the U.S. or any other nation being held hostage to Kim's demands for a nuclear deal similar to that extended to Iran.

But the options available to the U.S. and even China are running out as North Korea's progress on its nuclear and ICBM capabilities are advancing at a rate faster than any expert had expected. Kim has already voiced his refusal to consider any permanent deal to give up his nuclear arsenal, but an open-ended deal to gradually wind down the program over decades could be possible. Before the U.S. agrees to such a proposal, there will undoubtedly be a long rollercoaster ride of rising and falling tension.

Getting ready

Global equity markets, especially emerging markets, were until recently on course for one of their best years since 2011. The South Korean won and its stocks have been among the strongest performers in Asia so far this year. As these markets were due for consolidation, Trump's reckless comments turned out to be a chance for many investors to take profit.

Given the inevitability of further escalation before any resolution, equity investors should prepare for prolonged consolidation and avoid aggressive buying into the current correction. Year to date, traditional cyclical sectors have outperformed, led by tech. With China easing its monetary stimulus, South Korean exporters' earnings have already started to slow however.

Switching into defensive domestic sectors would be one way forward. South Korean banks continue to show structural improvements based on easing net interest margins and asset quality improvements.

An annual U.S.-South Korean military exercise will begin on Aug. 21. While North Korea always greets the training maneuvers with heated protests, Kim may this time be looking for an excuse for escalation, so the next ten days should be a period of caution for investors nervous about short-term weakness in Asian markets.

Since Trump's election victory, global equities markets have seen an impressive rally, with geopolitical risks barely priced in. In the coming months, fading monetary stimulus from the U.S. and growing escalation on North Korea will make it important to shift equity portfolios from momentum to value and quality. Another way to protect against the looming risk is to hedge the South Korean won.

The abundance of liquidity and strong investment sentiment is likely to keep stocks buoyed for the time being, but the outlook for 2018 looks much more challenging.

Peter S. Kim is a managing director and investment strategist at Mirae Asset Daewoo. The views expressed here are his own.

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