Korean conflict would hit trackers as managers move underweight

Tracker funds could have the highest exposure to a potential Korean conflict if Donald Trump’s nuclear rhetoric erupts into reality as active managers move underweight in the Asian country.

Besides the Barings Korea trust, the only UK retail fund dedicated to the country, the £429.3m SSgA Asia Pacific Ex Japan Equity Tracker has the largest allocation to Korea at 29 per cent, according to FE data.

Trump raised alarm bells last month when he told the UN that he would “totally destroy” North Korea if the US was “forced to defend” itself or its allies. The military implications could see South Korea caught in the crossfire with economic implications in Asia and beyond.

South Korea represents a significant part of the MSCI Emerging Markets index, second only to China, at 15.6 per cent. The State Street Global Investors fund tracks the FTSE Developed Asia Pacific ex Japan index, which has an even larger allocation of around a fifth of the benchmark.

There are 19 retail funds, including the Barings fund, with more than 16 per cent in Korea, with the Baillie Gifford Pacific and Invesco Perpetual Asian the active funds with the largest allocations, holding 22.4 per cent and 20.5 per cent respectively.

Among trackers, the Royal London Asia Pacific ex Japan, iShares Pacific ex Japan Equity, L&G Pacific and HSBC Pacific funds all have more than 20 per cent in the country.

Tracking the fall out

If the US did launch military action against North Korea, Pyongyang could retaliate by targeting South Korea, but debate is split on whether the economic and market impacts would be contained or widespread.

Tilney Group managing director Jason Hollands says an outbreak of nuclear conflict would lead to synchronised collapse in stock markets across the globe.

“Such as scenario would likely ignite an aggressive slide in risk assets globally and not just be limited to countries or regions in close proximity.”

But a Moody’s report issued this week said Japan and Vietnam would be the biggest economic casualties besides Korea from a protracted conflict and emerging markets generally would suffer outflows.

It forecasts the impact on the US and China would be limited.

“To a large extent gaming out which markets might be most impacted or what that could mean for the credit ratings on countries that could be destroyed somewhat misses the point,” Hollands says. “The outbreak of a potential nuclear conflict would almost certainly lead to synchronised collapse in stock markets across the globe.”

Moody’s argument is that a potential Korean conflict would dent Vietnamese exports and disrupt supply chains, while Vietnam’s debt burden, at 52.6 per cent to GDP, may limit the government’s capacity to respond to the economic shock.

It would also markedly hit Japan’s growth and stymie stabilisation in government debt.

Active managers move underweight

Hermes head of emerging markets Gary Greenberg says “some bizarre action” from the US is the biggest risk for emerging markets, where other conditions are “relatively benign”.

Korea is the fund’s biggest underweight at 5 per cent less than the index.

“It’s possible that if China were seen to be oppositional to the US in terms of North Korea or if the US did something militarily in terms of North Korea and China stood up it’s possible a trade war could ensue,” Greenberg says.

Alliance Bernstein Emerging Markets Equity portfolio manager Sammy Suzuki says he expects to continue to reduce his underweight position in Korea, which is currently 14.6 per cent. It is benchmarked against the MSCI index.

Suzuki is cautious about following predictions from political experts. “As an investor I’d say the track record of these political forecasts have been fairly weak. As a fund manager I think what you can do is manage risk rather than take a side.”

Suzuki says there is confusion about the form any Korean conflict would take making the ramifications unclear. “What actually happens on the ground and the rhetoric and what gets Tweeted may differ quite meaningfully,” he says.

Greenberg says the Hermes Global Emerging Markets fund is most cautious on the US from a global perspective.

“The US market has been enjoying one of the longest bull markets in history. If something went wrong people might sell and emerging markets are not uncorrelated unfortunately.”

While Moody’s has highlighted the risks to Japan and Vietnam, it says governments elsewhere in Asia, such as Singapore, Hong Kong and Taiwan, have “fiscal space” to buffer weaker exports to Korea.

It says timing could be crucial for Mongolian sovereign debt, noting that if financial markets seized up when large international sovereign bond repayments are due in early and mid-2018 the country could have trouble refinancing.