In a previous article, I described an investment opportunity in South Korea and expressed a positive outlook for the economy. Since the beginning of the year, South Korea has been one of the best-performing markets, and, in my view of the economy, performance is expected to hold.
Even though MSCI classifies South Korea as an emerging markets country, it can be compared to the developed markets based on its economy. South Korean is favorable relative to the US equity based on fundamentals (P/E - 13.55X vs. 21.72X, P/CF - 6.14X vs. 13.14X).
Also, Korean equity is one of the cheapest in the world based on the P/E ratio.
Source: Authors table based on the BlackRock/StateStreet data.
Nevertheless, South Korean equity has a primary source of risk – geopolitical risk – and in this article, I will explain the way to hedge the geopolitical risk and enhance overall portfolio returns.
North Korea has been a threat to South Korea for years. However, it hasn't always been on the front page of the news. This year was a game changer and expanding the military threat beyond the Korean peninsula to the US has transformed the geopolitical risk.
The graph shows that when tensions between the US and North Korea increased, the VIX, USD/JPY 1 month ATM option volatility increased and 10yr Treasury yield decreased. Thus, it shows the increasing demand for JPY and Treasury bills as market participants view them as a "safe haven" assets.
For the last month, the tensions between the US and North Korea have been intense. The US and South Korea imposed sanctions over the nuclear threat. China registered strong opposition to US sanctions on the Chinese companies that trade with North Korea.
As a result of the sanctions, last Tuesday, North Korea launched a provocative missile over Japan and informed the world that Guam was the next target. Donald Trump responded to the North Korean activity with his usual angry tweet. This weekend, North Korea performed another hydrogen bomb testing which was ten times stronger than the previous testing. Pyongyang is threatening to use the developed weapon against the USA, escalating even further the existing confrontation.
A key player in the conflict is China, which hasn't fully defined its position. On the one hand, the nuclear threat is serious. On the other hand, the possibility of Korean reunification doesn't align with Chinese plans. China and Russia have tensions over the THAAD missile defense system that complicates peaceful resolution. In addition, there are tensions between the US and China regarding the sanctions and possible trade tariffs.
The situation is incredibly complicated with a significant number of parties, each having their own interests. South Korean president Mr. Moon has a soft stance towards North Korea and is willing to meet the president of North Korea, a position and a pre-election promise that is supported by the majority of politicians. In his latest tweet, Donald Trump attacked Moon’s soft position regarding North Korea and US Treasury Secretary Steven Mnuchin has announced that he is drafting new sanctions against North Korea. Trump critics of the South Korean and Chinese position towards North Korea bring additional difficulties to conflict resolution.
South Korean financial markets have not been significantly affected by the increased threat from North Korea.
From a technical viewpoint, the KOSPI index volume hasn't increased for the last month above the average. The RSI shows that over the course of the year, the index was oversold, and for the last month was overbought (August 15th), and is currently neutral.
Given the number of countries involved in the conflict with their own political interests, spikes in the volatility of Korean and global markets can be expected. Therefore, hedging of existing positions is essential.
Due to the increased tensions with South Korea, the value of aerospace and defense, a subsector of the industrial sector of the S&P, has increased.
The aerospace and defense subsector includes the following companies: Transdigm (TDG), L3 Technologies (LLL), United Technologies (COL), General Dynamics (GD), TXT Group (TXT), Arconic (ARNC), Raytheon (RTN), United Technologies (UTX), Northrop Grumman Corporation (NOC), Lockweed Marteen (LMT) and Boeing (BA).
In addition to individual investments, investors can choose aerospace and defense ETFs such as PowerShares Aerospace and Defense ETF (PPA) or iShares U.S. Aerospace and Defense ETF (ITA) in which the above companies occupy the largest positions in the fund.
I have created a correlation matrix to show the correlation between South Korean equity and aerospace and defense sector companies. For the last year, the correlation was very weak and, over the last month, has decreased significantly.
The weak correlation reduces the volatility of the portfolio and is perfect for diversification purposes. In other words, the value of the aerospace and defense sector will rise when the tensions are increasing and the value of the Korean equity declines, driven by the uncertainty.
Besides the diversification purposes, the addition of aerospace and defense equity enhances the portfolio. Since the beginning of the year, the aerospace and defense sector has significantly outperformed industrials by 27.63% and the S&P 500 by 24.44%.
One of the budget proposals is to increase spending on defense while decreasing spending on other sectors. If the budget is approved with this proposal, the aerospace and defense sector will receive a nice boost in performance.
Next, I will compare PowerShares Aerospace and Defense ETF as representative of the aerospace and defense sector and SPDR S&P 500 Index ETF (SPY).
- PowerShares Aerospace and Defense ETF is more expensive than SPDR S&P 500 Index ETF based on the P/E (22.97X vs. 21.15X), P/CF (16.03X vs. 13.96X).
- While the dividend yield is almost the same, the earnings yield is lower for the PowerShares Aerospace and Defense ETF.
- Return on the equity is significantly higher for the PowerShares Aerospace and Defense ETF (17.75% vs. 13.51%).
- Since the beginning of the year, US equity has had a significant increase in value, boosted by the weakness of the dollar. As a result of positive earnings, P/E decreased from 22X to 21.20X.
- Meanwhile, aerospace and defense P/E rose to 21.62X from 18X, which was driven by the increase in price and spending expectations.
Nevertheless, US equity is still trading above the fundamentals, and if the market does not see the expected tax reforms, a correction should be expected.
The earnings for the sector are forecasted to increase by 28%, which will drive P/E ratio from 22.97X to 17.64X. Still, the sector is expected to be more expensive than the S&P 500, which makes it attractive from a fundamentals forecast.
Finally, the South Korean economy has a strong growth forecast with equity that is undervalued relative to equity worldwide.
- The geopolitical threat presented by North Korea brings volatility not only to the South Korean markets but markets worldwide.
- In this time of increased tensions, the value of the aerospace and defense sector increases, which allows hedging South Korean equity.
- Also, the aerospace and defense sector has strong potential due to a proposed increase in funding, which will lead to strong performance.
- Combining South Korean equity with the aerospace and defense sector will decrease the downside and increase upside potential.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in EWY, RTN, PPA over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.