Reunification Bets Survive Kim Jong Un’s Missiles: Korea Markets

 For all the concern over military tension between North and South Korea, stock investors are starting to bet the countries are headed toward reunification.

Shinyoung Asset Management this month opened the first South Korean fund focusing on equities that would benefit from a unified peninsula. The benchmark Kospi index rose to a two-week high yesterday, even after North Korea fired 46 short-range rockets over the weekend, and the Kospi 200 Volatility Index, a gauge of demand for protection against plunging shares, is trading near its record low in December, about half the level when the North detonated its first nuclear device in 2006.

kimjongun_small Reunification Bets Survive Kim Jong Un's Missiles: Korea Markets

While Kim Jong Un’s nation remains isolated more than 60 years after the end of the Korean war, officials from the two countries held the first high-level talks since 2007 last month. South Korean President Park Geun Hye said in January that combining the North’s natural resources with the South’s high-tech economy would create a “bonanza,” even as the finance ministry estimates reunion may cost almost $600 billion.

Unification “is inevitable before this decade is over,” Jim O’Neill, the former chairman of Goldman Sachs Asset Management who created the BRIC moniker for the biggest emerging markets in 2001 and is now a Bloomberg View columnist, said in an e-mail on March 19. “It should boost equities by raising the potential future earnings stream from a stronger growth trend.”

South Korea’s Kospi has slipped 3.3 percent this year. The won weakened 2.6 percent against the dollar, while the yield on three-year government bonds rose 3 basis points to 2.92 percent.

Stock Swings

Still, the Kospi 200 Volatility gauge, which measures the cost of using options to protect against stock-market swings, closed at 12.84 yesterday, versus 22.65 after North Korea detonated a nuclear device in October 2006 and 14.6 when the regime announced its highest combat level in March 2013. The index has traded at an average level of 23.51 during the past decade.

Gauges (KOSPI) of cement and medical companies, which would be some of the top beneficiaries of South Korean spending to integrate the North’s economy, have climbed more than 15 percent to lead gains in the Kospi since Park extolled the potential for a bonanza in a New Year press briefing on Jan. 6.

“The market seems to be buying the reunification idea more and more,” said Huh Nam Kwon, who helps oversee about $7.7 billion as the chief investment officer at Shinyoung Asset in Seoul and started the unification fund this month after outperforming 84 percent of peers tracked by Bloomberg the past year with the Shinyoung Marathon Securities Investment Trust Equity fund. “The time is ripe to prepare.”

German Precedent

Shares of Emerson Pacific Inc. (025980), Romanson Co. and Shinwon Corp. (009270) — which all do business in the Gaeseong industrial complex jointly run by the two Koreas — have rallied more than 28 percent during the period. Maeil Dairy Industry Co., a producer of powdered milk and baby formula that Huh says would enjoy a surge in demand from North Korean consumers, advanced 7 percent even as the Kospi slipped 0.4 percent.

Germany’s unification more than two decades ago may provide a guide for what to expect in Korea, according to O’Neill. The DAX Index (DAX) of shares in Frankfurt rose 289 percent during the 10 years after the Berlin Wall fell in 1989, more than twice as much as the MSCI All-Country World Index, data compiled by Bloomberg show. Park is scheduled to visit Germany for four days starting today in part to learn about the nation’s experience combining its east and west.

Officials from the two Koreas, which remain technically at war after their 1950-53 conflict, met inside the heavily-fortified demilitarized zone in mid-February for the first high-level talks in more than six years. About a week later, the countries allowed families separated by the war to meet in the Mount Geumgang resort in North Korea.

Unification Poll

North Korea is showing no signs of giving up nuclear arms, U.S. Secretary of State John Kerry said in Seoul last month, a precondition for talks with the Obama administration. The regime rejected the South’s offer for talks on holding regular family reunions, the Unification Ministry in Seoul said March 6.

The share of South Koreans who view unification as necessary fell to 54.8 percent last year from 57 percent a year earlier, according to a study released in November by the Institute for Peace and Unification Studies at Seoul National University. The ratio drops to 40.4 percent among respondents between 19 and 29 years old.

“I don’t think it will happen anytime soon,” Mark Mobius, the executive chairman at Templeton Emerging Markets Group, who oversees more than $50 billion in emerging markets, said in an interview from Bucharest yesterday. “It would be quite difficult to foresee a timetable at this stage of the game.”

Wealth Gap

Unification may lead to social unrest given the cultural differences and wealth gap between the two countries, said Hong Soon Jick, a senior research fellow at the Hyundai Research Institute.

Kim, who took control in Pyongyang after his father Kim Jong Il died in 2011, should face trial for crimes against humanity, according to a United Nations inquiry released on Feb. 17. While he projects an image of socialist prosperity in the North, the UN report found evidence of “extermination, murder, enslavement, torture, imprisonment, rape, forced abortions and other sexual violence.”

Bond Outlook

“It’s inevitable that social conflict will emerge soon after reuniting of the two Koreas,” Hong said by phone on March 21. “The side effects will be even bigger if reunification arrives sooner than expected, with risk management and economic costs piling up.”

A combination may weaken the South’s public finances, put pressure on the won and lift government borrowing costs, according to Shinyoung Securities Co. The cost of a merger may total as much as $591 billion over a decade if it occurred in 2020, estimates from South Korea’s finance ministry show.

The process would be a “strong negative” for South Korean bonds and would spur foreign investors to pare holdings, Hong Jung Hye, a Seoul-based fixed income analyst for Shinyoung Securities, wrote in a March 10 report. Germany’s 10-year bond yields climbed from about 7.2 percent when the Berlin Wall fell to 9.1 percent a year later, according to data compiled by Bloomberg.

Park has described the resumption of reunions, previously held in 2010, as the starting point for improved relations. They follow a November agreement between Hyundai Merchant Marine Co., Posco, Korea Railroad Corp. and Russia to build a rail link between the Russian border and a port in the North.

‘No Knowing’

A Hyundai Research Institute index measuring “peace sentiment” on the Korean peninsula climbed to 42.3 in the fourth quarter of 2013, the highest level since 2009, from 33.9 in the previous quarter.

“There’s no knowing when unification will actually take place, but we will do our best to hasten the day,” Park said in a January interview at the presidential Blue House office in Seoul.

North Korea also views unification as one of its top national goals while blaming South Korean conservatives and U.S. “imperialists” for blocking it.

Investor Jim Rogers, the Singapore-based chairman of Rogers Holdings, says the two Koreas may combine within five years.

Korea Discount

“It could happen even sooner than most people expect,” Rogers, who visited the North in 2007, said in a phone interview on March 20. “Once the war discount disappears, all South Korean shares will go up.”

The country’s equities have traded at a consistent discount versus global stocks during the past decade, in part because of the risk of conflict with the North. The Kospi is valued at about the same level as its net assets, versus a price-to-book multiple of 2 for the MSCI All-Country gauge.

Combining the North’s workforce and its natural resources such as coal with South Korea’s economy would be a “major positive” for the country, said Ruchir Sharma, the head of emerging markets equity and global macro at Morgan Stanley Investment Management, which oversees about $373 billion.

Unification would boost South Korea’s potential growth rate by as much as 1.34 percentage points a year, the nation’s finance ministry said in a December 2012 report. The working-age population would climb to 70.2 percent of the total by 2050 if the two countries combine, up from 67.9 percent without unification, the ministry said in February 2013.

“It is not unthinkable that South Korea could grow significantly larger in a single leap if a unified Korea emerges in coming years,” Sharma, who identified the South as one of the world’s “Breakout Nations” in his 2012 book of the same title, said in an e-mail interview on March 21. “South Korea’s economy has shown an unusual ability to adapt to changing global trends, which may bode well for its ability to adopt the shut-in Communist society of the North.”