Investors are focusing on earnings - not North Korean missiles

5 min read

The recent escalation of activity in North Korea has led to a range of questions over what next, including what this may mean for investments, both as a result of diplomatic efforts to contain the situation or if further conflict rises. Investors have grown accustomed to accounting for North Korea’s behaviour in the past – and it looks likely they will continue to do so.

The background to activity 

North Korea’s missile program has been going on sporadically since the late 1970s, but seems to have escalated in 2017. Early forms of the program saw a litany of failures and perceived political gestures while more recent times has seen successful missile testing and in turn, increased focus on what North Korea’s capabilities and intentions are.

In recent months, the world has seen North Korea’s 14th missile test for the year, reports that it now possesses a miniaturised nuclear warhead, threats to Guam as a US Pacific territory, two missile launch that overflew Japan in late August and September, and a sixth nuclear test with claims the test was a hydrogen bomb.

Responding to concerns over the heightened technological capability, the United Nations has imposed new restrictions on North Korea which aims to cap North Korea’s oil imports, ban textile exports, end additional overseas labourer contracts, suppress smuggling efforts, stop joint ventures with other nations and sanction designated North Korean government entities.

But are these concerns also translating through to investor activity?

Rinse and repeat

Markets have a history of taking North Korea’s antics in their stride.

The late-August test saw the US stock market’s “fear index,” the Volatility Index, surge 11.8% in a day, before receding. But that is off a low base: the VIX is close to multi-decade lows.

The futures version of the Dow Jones Industrial Average quickly fell by more than 100 points after the most recent test, as did the physical market the next day, but it staged a turnaround as the day went on and closed higher, as did the broader S&P 500 Index.

The markets closest to the trouble were not unduly concerned, either. The Korean Share Price Index (KOSPI) was down less than 1%, as was the Nikkei in Tokyo and the Hang Seng Index in Hong Kong.

These are markets that have been rising for some time: the Nikkei has put on 32% since June 2016; the Hang Seng Index is up 53% since February 2016; and the KOSPI has gained 29% since February 2016. The markets have ridden the wave of upbeat economic data and improving company earnings.

There is an element of the markets getting used to North Korea’s behaviour, and the resultant step-up in diplomatic pressure on the hermit country to rein in its weapons programs: these are the accepted steps in the performance.

Real expectations

Markets do not expect actual hostilities to rise from the current activity in North Korea, based on the past. Should this change, markets are likely to respond rapidly to concerns and this is most likely to trace to the markets of those countries in closest geographic proximity.

The South Korean capital Seoul is only about 50 kilometres from the North Korean border and host to about 40,000 US troops. Similarly, Japan is just across the sea, and also hosts US military bases. Japan and South Korea are highly developed and densely populated. Alongside the potential for physical damage and loss of life, any war in North Asia would have economic consequences.

The trade flows to and from North Asia are significant, meaning that any conflict would reverberate around the world quickly, as supply chains were disrupted. Japan is the world’s largest importer of liquefied natural gas (LNG); South Korea is one of the biggest buyers of coal and sellers of steel. Along with China, South Korea and Japan are responsible for about 84 percent of the world’s iron ore seaborne trade, according to Citigroup, and nearly half of the world’s seaborne imports of metallurgical coal, according to UBS.

About 40% of the world’s finished and semi-finished steel exports originate from China, South Korea and Japan, says Bloomberg. Capital Economics says South Korea is the world’s fourth-largest producer of electronics goods on a value-added basis, accounting for just over 6% of global production. And South Korea is China’s fourth-largest trading partner, providing critical inputs on which many Chinese companies rely, such as semiconductors and display panels. Any interruption to this flow would quickly feed into higher prices for electronic products around the world, and thus global inflation.

Investment markets in North Asia

North Asian markets are aware of these potential threats but have held their focus on economic growth and company earnings. In Japan, for example, the economy is enjoying its longest expansion in more than a decade: the Japanese economy grew at an annualised rate of 4% in the June quarter, easily exceeding the 2.5% rise forecast in a Reuters poll. That made six quarters in a row of growth. 

Japanese company earnings are strong. Net profit at Japanese companies for the March 2017 year-end climbed to a record high, with nearly 30% of firms reporting their highest-ever profit. In the June quarter, a record 68% of listed companies reported higher net profit than a year ago. That explains why the Nikkei index is up almost 19% in 2017. 

In Korea, the company earnings picture is also very strong.  According to analyst estimates collated by Bloomberg, the KOSPI index companies will lift their aggregate earnings by 88% this year, to the highest level since 2010. That explains why the KOSPI – while it has eased back from the record high it reached in July – is also up almost 19% this year. 

The Seoul index has also had to deal this year with a major political crisis, with the impeachment in March of former President Park Geun-hye, who was charged with corruption, followed by fresh elections in May, which saw Moon Jae-in – who advocates dialogue with North Korea – take over the country’s leadership. It was no coincidence that Kim Jong-un ramped up the sabre-rattling while his southern rival was politically leaderless. But with South Korea’s political crisis solved by fresh elections, the KOSPI surged by 6.4% in June.

Next steps

Left to their own devices, the North Asian stock market indices will continue to focus on company earnings and improving global economies. While unlikely, if actual conflict starts, they would be expected to slump, with this extending to other share markets. How markets would react on a longer term basis in this scenario would depend on the type and scale of conflict – and reaching a resolution.

It’s worth noting that investment markets have tended to follow a similar pattern with most geopolitical concerns and conflicts over time, with an initial sharp fall and subsequent bounce back on expectations of a resolution. One example of this was the 14 per cent fall of the US share market at the start of the Iraq invasion in 2003. The market in turn rose 27 per cent from its low point after six months as the market priced in expectations for an end to conflict and its views on positive outcomes from this.

For more information, speak to your financial adviser

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Information current as at 12 September 2017. This article provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such. This information does not take into account your personal objectives, financial situation or needs and so you should consider its appropriateness, having regard to your personal objectives, financial situation and needs having regard to these factors before acting on it. This article may contain material provided by third parties derived from sources believed to be accurate at its issue date. While such material is published with necessary permission, no company in the Westpac Group accepts any responsibility for the accuracy or completeness of, or endorses any such material. Except where contrary to law, we intend by this notice to exclude liability for this material. 

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