2017 was characterized by a marked deterioration in relations between the United States and North Korea. Kim Jong Un launched at least 20 missiles last year with each test showing improved range and technical capabilities. In response, the UN Security Council unanimously adopted US-drafted economic sanctions against North Korea and fiery words/tweets were exchanged between President Trump and Kim Jong Un.

What a difference a few months makes! Since January of 2018 there has been a definite reversal in the trajectory of the North Korean situation. In late January, Kim Jong Un made peace overtures to South Korea in conjunction with the latter hosting the 2018 Winter Olympics. North Korea sent athletes to compete and, more importantly, Kim sent his sister as a diplomatic envoy to the Games.

Since then relations have continued to improve. Kim Jong Un recently left North Korea (very rare) and travelled to China to meet with President Xi. Kim Jong Un is also slated to meet the South Korean President Moon Jae-in later this week for the first time since 2007. And of course, there is the much anticipated meeting between Kim and Trump in May/June of this year.

In this note we explore why the North Korea situation seemingly reversed course after an extended period of deterioration, and outline which stocks in Korea would benefit if relations continue to improve.

Why Now?

Our view is that the improvement in relations is not due to a sincere change of heart by any of the parties involved but is driven by immediate economic and political realities in North Korea and the US, respectively. With respect to economics, the sanctions imposed by the UN in 2017 have been very damaging. This is primarily because China has adhered the sanctions this time, whereas in the past they continued to provide financial support and export oil to North Korea.

Apparently North Korean foreign exchange reserves have dwindled to a dangerously low level and the country is expected to run out of reserves completely by October/November of 2018. This provides Kim Jong Un with a significant economic incentive to make peace (at least temporarily). On the other side of the equation, mid-term elections are fast approaching in the US and it is much more palatable to go to the polls with a major geopolitical win than with ICBMs being fired over Guam.

Given these considerations, our view is that while long term denuclearization is still very unlikely, some sort of deal is a possibility in the near term.

What Stocks Would Benefit?

If relations continue to improve it would obviously be positive for the Korean stock market. Many investors don’t realize that after China, Korea is the second largest weight in the MSCI Asia ex Japan Index at 17.5%. More importantly, it is a large and consistent underweight by foreign funds that manage money in Asia and Emerging Markets. Specific stocks that would benefit if a peace deal is achieved include:

Hyundai Engineering and Construction and POSCO: Hyundai E&C has done construction work in North Korea in the past. Presumably, if there is some sort of deal, there will be economic development spending for North Korea and this stock would be a direct beneficiary. POSCO, the largest steel company in Korea, would also benefit.

Cosmetics and Duty Free Companies: Korean cosmetic stocks like AmorePacific and LG H&H and Duty Free stocks like Hotel Shilla, were hurt last year when China imposed a travel ban to South Korea over the deployment of THAAD (Terminal High Altitude Area Defence). If there is a peace deal, presumably the THAAD issue would die down and returning Chinese travellers would boost sales of Korean cosmetics and Duty Free companies.

Samsung Electronics: While there are no direct links between the North Korean situation and Samsung Electronics, Samsung is a mega weight in the Korean market accounting for 20% of the KOSPI Index and 27% of MSCI Korea. If investors want to reverse their long held underweight position in Korea, Samsung is a good option. The stock trades at only 7x PE with a 3% dividend yield.

Conclusion

We think that long term denuclearization of North Korea remains very unlikely. However, we concede that a deal is a possibility in the short term given both sides are incentivized to do so for domestic economic and political reasons. This may end up being a “buy the rumour, sell the news” type of event, but the meeting between Trump and Kim is still weeks away and stocks can move significantly between now and then. We like stocks like Hyundai E&C, POSCO, Amorepacific and Samsung.

About Ellerston Asian Investments (ASX:EAI)

Ellerston Asian Investments (ASX:EAI) is a concentrated large cap portfolio based on high conviction best ideas which is benchmark independent. Providing investors access to high growth opportunities throughout Asia via a highly experienced and specialised team.

AUTHOR
Mary Manning

Mary is a member of the investment team and is a Portfolio Manager for Ellerston’s listed investment company, Ellerston Asian Investments Ltd. Mary has over 17 years investment management expertise and joined Ellerston in 2012. Mary first worked in Asia in 1997 and has been investing in the region since 2001. Prior to joining Ellerston Capital, Mary worked at Oaktree Capital in New York and Singapore. In Singapore, she was the sole person responsible for financial sector investments for the firm’s Global Emerging Markets Hedge Fund.

Mary also worked as an investment analyst at Soros Fund Management in New York, the investment vehicle of George Soros. She focussed on investments in the financial sector in the US, Asia, including Japan and Europe.

Mary has a PhD in Economics from the University of Sydney, an MBA from Harvard Business School and a Bachelor of Commerce degree from the University Of Calgary, Canada.