Investors should stay focused on what’s driving assets, tune out North Korea ‘noise’
‘Investors see no point in pricing in a nuclear war – or, what one analyst aptly calls, an “extinction event” – as the consequences do not bear thinking about’
Here we go again.
Three weeks after a sharp rise in tensions on the Korean peninsula sent shudders through financial markets, the firing on Tuesday of a ballistic missile by North Korea across the Japanese island of Hokkaido once again triggered a rush into so-called “haven assets”, with the price of gold hitting its highest level this year and the Japanese yen and the euro strengthening further against the dollar.
Stock markets came under strain, with European equities dropping to their lowest level since February, while the yield on benchmark 10-year Treasury bonds fell to just 2.1 per cent, its lowest level since just before last November’s US presidential election.
Given that sentiment was already starting to deteriorate before Tuesday’s missile launch, the dramatic escalation in the military stand-off in Asia – Pyongyang has not fired a missile that has overflown Japan since 1998 – puts markets under more strain just when Donald Trump’s crisis-ridden presidency and the removal of monetary stimulus by leading central banks are unsettling investors.
Not surprisingly, Asian markets, and in particular South Korean assets, are especially vulnerable to a further deepening of the crisis.
Emerging Asian equities were barely in positive territory in dollar terms in August, compared with gains for Latin American and Emerging European stocks of 4.5 per cent and 5.5 per cent respectively, according to MSCI. The Kospi, South Korea’s main equity index, is down 3.2 per cent since the end of July, having shot up 11 per cent during the preceding three months. The won, South Korea’s normally Teflon-like currency, has also become more volatile, losing nearly 3 per cent against the dollar between July 26 and August 10 before strengthening in the second-half of August.
JPMorgan noted in a report published in early August that the fierce rally in emerging Asia since the beginning of this year – the region’s equity markets have surged nearly 30 per cent while returns on local currency government bonds exceeded 10 per cent in dollar terms in the first-half of 2017 – was bound to lose momentum.
Emerging Asian equity funds suffered outflows in July for the first time this year. The selling pressure persisted in the first-half of August, with investors withdrawing US$1.5 billion from South Korean equity funds, and Indian, Taiwanese and Indonesian stock funds suffering outflows of US$655 million, US$632 million and US$210 million respectively, according to JPMorgan.
Make no mistake, emerging Asia’s markets are being put to the test.
Yet some perspective is in order.
Firstly, while Asian markets are more exposed than other emerging market regions, a full-scale military conflict in nuclear-armed North Korea would be disastrous for all regions and asset classes. Investors see no point in pricing in a nuclear war – or, what one analyst aptly calls, an “extinction event” – as the consequences do not bear thinking about.
Secondly, the recent deterioration in sentiment towards emerging Asia stems from a number of factors, including the increasing uncertainty surrounding leading central banks’ exit from ultra-loose monetary policies and, just as importantly, a growing sense among investors that the rally in global equity and bond markets has gone too far.
Thirdly, on Wednesday, sentiment was already starting to recover somewhat, with Asian equities – including South Korean shares – climbing again in a sign that international investors believe a solution will eventually be found to de-escalate tensions on the Korean peninsula.
Fourthly, sentiment towards emerging markets is still favourable. Last week, investors bought US$1.4 billion of developing economies’ local currency government bonds, while in July investors bought over US$10 billion of emerging Asian local debt – the fourth straight month when inflows exceeded US$10 billion, according to JPMorgan.
Fifthly, an escalation in tensions on the Korean peninsula is nothing new for investors in emerging Asia.
What is new, however, is a highly unpredictable and confrontational US president. In a note published last month, AllianceBernstein argued that the real threat to Asian markets stemmed from Trump’s aggressive behaviour, and went so far as to say that the US is becoming a “rogue state”.
Yet the more markets fret about Trump, the sharper the decline in the dollar, which boosts the value of emerging Asian currencies and local bonds. The dollar index – a gauge of the greenback’s performance against a basket of currencies – has dropped 10 per cent this year, mostly because of waning confidence in Trump’s pro-growth policy agenda.
While sentiment towards emerging Asia could still deteriorate sharply – either because the Federal Reserve removes stimulus more aggressively than markets expect or because of renewed fears about China’s economy – the catalyst is unlikely to be North Korea.
Still, if tensions on the Korean peninsula serve to temper a rally that was overdone to start with, this will be no bad thing.
Nicholas Spiro is a partner at Lauressa Advisory