Now that the U.S.-led war against Iraq appears to be winding down, increased U.S. political and military attention may swing to North Korea, where the tension between the two countries has already led to one major casualty - the South Korean stock market.
That market's value has declined almost 30% during the past 12 months as investors speculate about the effects of military and political instability or the likelihood of the "unthinkable" - a nuclear war on the Korean Peninsula.
"The Iraq war is becoming yesterday's story. North Korea is tomorrow's story," said Paul Psaila, a executive director, emerging markets equities, Morgan Stanley Investment Management, New York. "The focus will turn to North Korea quickly," after the situation in Iraq quiets down, he added.
Such a conflict could have far-reaching ramifications for economies in the Far East, said Sun-Bae Kim, chief economist for the Asia Pacific region at Goldman Sachs (Asia) LLC, Hong Kong. "If the U.S. took unilateral action against North Korea, it would make the Iraq situation look like a picnic. It would involve China, Japan and Russia and hurt all of their economies," he said.
Such an action could stall China's currently strong economic growth, hurt Japan's already weakened economy and put the brakes on Russian stocks, which have among the best performance of any in emerging markets countries so far this year.
South Korea's economy and financial markets have already felt the effects.
The Morgan Stanley Capital International Korea index is down 29% year over year for the period ended April 7, and is down 12.61% year to date. South Korea's inflation rate has risen to 3.5% this year, from around 2.5% to 3% last year, according to Mark Headley, president of Matthews Asian Funds, San Francisco, and co-manager of the firm's Korea fund.
With the South Korean stock market trading at about six times earnings, investors acknowledge that it is cheap compared with other emerging market countries, whose stocks are trading at an average of 8.8 times earnings. But many are still hesitant to make new investments because of the political and military instability in North Korea. Most emerging markets portfolios now underweight South Korea, compared to the MSCI Emerging Markets Free index, about 20% of which is in South Korean stocks.
George Hoguet, director of emerging markets at State Street Global Advisors, Boston, said his firm is 3% to 4% underweight South Korea in its emerging markets portfolio, which includes "all of the major stocks in the South Korean market," such as Samsung Electronics Co. Ltd., Hyundai Motor Co., Kookmin Bank and POSCO Steel Works.
Mr. Hoguet said there was a confluence of factors causing SSgA to underweight South Korea in the past few months: concern over North Korea; overexpansion of credit card debt in South Korea; Japan's economic weakness and its effect on trade with South Korea; and concerns over corporate governance issues.
Mr. Psaila said Morgan Stanley's emerging markets equity portfolio is neutral on South Korea, according to the firm's latest public data.
A lot of uncertainty
Said David Holstein, director of international investments for General Motors Asset Management, New York, which runs the $73.6 billion General Motors Corp. pension fund: "Our current posture is underweight (South Korean stocks) because there is a lot of uncertainty, both economic and geopolitical."
Some investors think the low valuations could provide buying opportunities, but they acknowledge that the political and economic risks must be weighed carefully.
"South Korea is trading at incredibly low valuations. The possibility of the market going up 20% is as great as the market going down another 20%," said Mr. Headley.
He pointed out that the KOSPI - the South Korean stock exchange - is down about 35% over the last 12 months, through April 7. "This market has taken a severe blow over the last 12 months," he added.
John Lee, co-manager of New York-based Deutsche Asset Management's Korea Fund, said the fund now is valued at about $750 million, down from around $1 billion a few months ago. The reason: selling by panicked investors.
Mr. Hoguet thinks the South Korean stock market will go down more before it turns around, even assuming the crisis with North Korea gets resolved.
"It's not just the political situation that has hurt it, but there have been corporate scandals and credit card scandals as well," Mr. Hoguet said.
Corporate accounting fraud was discovered at SK Global, Seoul, the trading arm of what had been the old SK Group, one of the largest of the chaebols that dominated the South Korean economy.
Mr. Headley said that scandal had caused some of the sell off in the South Korean stock market over the last few weeks.
Government officials moved decisively, however, arresting high-ranking SK Global officials including Chairman Chey Tae Won, which is a positive sign for the South Korean economy, Mr. Headley said.