When we last commented on the situation in South Korea , we concluded that even with an increased risk of a flare-up in tensions over North Korea…
“…a great deal negativity has already been incorporated into South Korean equities, making us guardedly optimistic about the outlook.”
Since we wrote that back in December, South Korea crowd-sourced sentiment has improved markedly. The negativity generated by last year’s political scandal, which ended up costing Park Geun-hye her presidency, has now been fully unwound – a shift in public perception that has helped propel the KOSPI index some 20 percentage points higher.
Exhibit 1: Crowd Sourced Sentiment – South Korean Equities
With North Korea back in the headlines for successfully showcasing its military capabilities – this time carrying out its first successful launch of an intercontinental ballistic missile (Hwasong-14) does this relatively sanguine assessment still hold?
South Korean equities – indeed global asset markets more generally – may have barely flinched on the North Korea leader’s Independence Day “gift to American (expletive removed)” suggesting the answer is yes. However, this time around we are more circumspect.
The speed and direction of travel of South Korean sentiment (positive momentum) is a short-term market support. However, as we alluded to in the aforementioned quote, significant crowd pessimism provides, in some sense, “emotional insulation” to future negative developments because as every investor recognizes when everyone is bearish the incremental impact of bad news is lower than when everyone is bullish and vice versa. Hence, with crowd sentiment towards South Korea now best considered neutral this insulating effect has been reduced. This is even more pertinent for the KRW given the crowd is moderately bullish – see exhibit below.
Exhibit 2: Crowd Sourced Sentiment – South Korean Won
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So, notwithstanding the resilience of South Korean asset markets to the recent North Korean missile launch, we judge their vulnerability to a serious escalation in regional geopolitical tensions to be greater than they were last December.
But what is the risk of a more serious escalation?
As President Trump recently acknowledged, the North Korean problem is complex and not as easy to resolve as he had previously thought (a change of view prompted by a 10-minute conversation with Chinese President Xi – an alarmingly short period of time). This is because the desired outcomes for the key players involved are, in many regards, mutually exclusive.
The longstanding goal of North Korea is to have a unified peninsula under its control. It also believes in the strong deterrent effect of having a nuclear missile capability as a means to safeguard the regime’s existence. Hence, there is a strong incentive to develop nuclear missiles and to display their use publicly because as the character Dr Strangelove notes in Stanley Kubrick’s film of the same name.
“The whole point of the doomsday machine…is lost if you keep it a secret!”
The deterrent only works if everyone knows about it.
However, the tests which ensure everyone knows about it, are – for totally understandable reasons – alarming to North Korea’s neighbours. This not only includes South Korea, whose existence as an independent democratic country is contrary to the North’s longstanding goal, but also Japan, a country with a long history of military conflict on the Korean peninsula and who is, along with the South and much to the annoyance of Pyongyang, a key US alley. Indeed, the latest missile landed – like others before it – in the Sea of Japan, prompting Japanese PM Abe to warn about the “escalating” threat from North Korea.
As many commentators recognize, the key to solving the North Korean problem lies in the hands of the two superpowers in the region – China and the US. Both are opposed to a nuclear North Korea, but neither wants to see the peninsula unified under the control of the other. For China, North Korea represents a critical buffer zone to US influence, whereas for the US, a China-influenced united Korea would significantly strengthen its influence in the Asia-Pacific region further challenging US dominance.
A unified, non-aligned, Korea is considered by many to be the “first-best” solution but it is hard to envisage how such an outcome would be stable, assuming it could even be achieved in the first place, given the strategic importance both sides attach to this territory.
In an attempt to secure such an outcome, during last month’s joint press conference with new South Korean President Moon Jae-in the US called on…
“…regional powers and all responsible nations to join us in implementing sanctions and demanding that the North Korean regime choose a better path and do it quickly and a different future for its long-suffering people.”
This was a clear call on China to put more pressure on North Korea – something it is well positioned to do given how heavily reliant North Korea is on Chinese imports. However, this it is not a straightforward, or risk-free, approach.
China is very concerned that applying harsh economic sanctions could destabilize North Korea causing an exodus of refugees into China with potentially destabilizing effects on its own country. Even more concerning from the Chinese perspective, it could provide just the excuse the US needs to put troops on the ground, something that China is vehemently opposed to for the aforementioned reasons.
Such arguments are hardly new. Deft political handling and diplomacy could assuage China’s concerns, but these are hardly skills associated with President Trump or the key players in his administration. Moreover, while Sino-Chinese relations got off to a good start when President Trump and President Xi met at Mar-a-lago they have cooled significantly since then. Amongst other things, President Xi has been critical of recent US measures to impose sanctions on a Chinese bank for dealing with North Korea not to mention the USD 1.3bn arms sales to Taiwan. Meanwhile, Trump has been critical of what he perceives as China’s failure to influence North Korea, rhetoric that has only increased subsequent to the missile launch – see exhibit below. This is not exactly a backdrop conducive to securing a political solution as the lack of progress on this issue at the G20 summit reinforced.
Exhibit 3: Trump Diplomacy Twitter-style
That said, what is particularly concerning to us, is that unlike the past, maintaining the status quo – an outcome that has historically suited China’s interests – looks increasingly untenable.
As mentioned above, Kim Jong-un considers having the capability to engage in nuclear strikes as paramount to his regime’s survival. This gives him a strong incentive to accelerate the missile programme to maximize the deterrence effect even in the face of opposition from the US, China or the broader international community.
Foreign observers have concluded that with this latest missile launch North Korea has now advanced its programme such that it is able to strike (albeit not necessarily one equipped with the nuclear warhead) US soil. For President Trump, a man who clearly wishes to be seen as a strong, decisive, leader, this development represents a very serious challenge. If, as he seems to now be implying, China is not up to the job in dealing with North Korea, and prevarication is unacceptable, then military strikes could increasingly be viewed as the only viable option left on the table to deal with the threat emanating from North Korea. Moreover, while Syria was a very different proposition to a nuclear-capable North Korea, his consent to those airstrikes amply demonstrates his preparedness to deploy such means unilaterally.
In addition, and admittedly a bit left-field in terms of thinking, hawks in Washington may find Japan a more willing supporter for an aggressive response than was previously the case. Abe’s LDP Party just suffered a heavy defeat in Tokyo’s assembly elections – a result the party will take notice of as these elections have proved a harbinger for LDP general election fortunes in the past. Abe’s immediate future as PM is not in jeopardy. But what is in jeopardy is his plan to reform Japan’s constitution, specifically, his attempt to change Article 9 which states Japan will “forever renounce war” and legally recognize Japan’s Self-Defense Forces as the country’s military.
To make such a constitutional change, which Abe has promised to do by 2020, requires a two-thirds majority in both houses of parliament, followed by a majority in a referendum. This is a tall order. But one should never underestimate a politician’s desire to exploit a crisis to secure his (or her) legacy even if it results in a negative economic shock. (Crowd-sentiment towards Japanese equities has risen markedly over recent months, suggesting they are also vulnerable to a serious escalation in regional geopolitical tension – see exhibit below.)
Exhibit 4: Crowd-sourced Sentiment – Japanese Equities
In conclusion, it has long been recognized (well by almost everyone except President Trump until recently) that resolving the North Korean problem was extremely difficult given the desired outcomes of the key players are mutually exclusive. This remains as valid today as it was previously. However, what is new, it that the latest North Korean missile strike has created an increased sense of urgency in the US to deal with the threat from Kim Jong-un regime. Maintaining the status quo is increasingly untenable and Trump’s faith in the ability of China to influence the wayward nation is weakening. As a result, it is becoming more difficult to dismiss such episodes as another North Korean sabre-rattle whose economic and financial impact should be faded.
The “era of strategic patience” in North Korea appears to have been replaced by an “era of strategic impatience”. Yet, the latest crowd sentiment readings, combined with the mute market reaction to this week’s North Korean missile launch, suggests investors have not yet fully appreciated the change in the political landscape.
 A claim made by North Korea that has been subsequently confirmed by the US.
 Donald Trump to respond in typical fashion with a pithy tweet asking whether Kim Jong-un “had anything better to do with his life” – oh, the quality of political discourse these days!
 Recall our sentiment data are calibrated such that zero equals the long-run average which we consider neutral. A positive reading therefore represents a more constructive crowd view towards the asset in question.
 The film’s full title was “Dr Stranglove or: How I learned To Stop Worrying and Love the Bomb”. We would not go that far.
 The dispute between Japan and China over the sovereignty of the Senkaku/Diaoyu Islands is a pawn in a game of territorial chess and a perennial potential flashpoint.
 For those interested in knowing more we recommend Scott Laprise’s series of research notes on China’s views on North Korea published earlier this year as they were very informative.
 Alaska according to most estimates.