South Korean PMI shows activity picking up last month at the fastest rate since early 2013. This is some welcome news for the global economy, as there is no economy more reflective of global macro conditions like South Korea. I think is it more of a blip than a long-run trend. The South Korean economy is very reliant on the exports of industrial conglomerates called chaebol on the one hand, and high household debt is a drag on the domestic economy.
So I was looking into the proposed solutions to these problems in the South Korean Ministry of Finance’s three-year plan, called “The Era of the People’s Happiness and Preparation of Unification”. It appears that such flowery titles are not uncommon in Korea, being a less cynical place and time. It also appears that Korean unification is part of the proposed solution. South Korean politicians pay plenty of lip service to it at the very least.
Unification seems inevitable. North Korea offers an important security enhancement to the South: some degree of nuclear capability. It is a meaningful deterrent for a nation that has been wedged for millennia between Chinese and Japanese aggressors. On the other hand, North Korea is one of the most repressed prison-states that ever existed. The entire regime from the top down has a decades old deliberate strategy of dehumanization, treated the people not as slaves, but as animals. I cannot imagine the nightmare stories that will come out of that country once Kim Jong-Un hangs with his ankles in the air. It is essentially untouched by the modern world with tens of millions of cheap laborers to build factories around and unleveraged consumers to potentially in-debt. There is no way that the country will not be grafted into the global economy: the system is far too rapacious to escape. South Korea is ideally positioned to make this happen.
The North Korean economy has been in a state of slow death literally for decades. Scott Jenkins wrote in his memoir of life in North Korea “The Reluctant Communist”:
Today, like everything else in North Korea, the army has completely degenerated. The troops are starving along with the rest of the people. The enlisted men are little more than kids in rags, and the officers are usually corrupt. And one knows anything about military subjects anymore. Begging became common people would come to our house asking for food.
This was written over ten years ago. And even before this period, he states:
North Korea’s version of the high class is not the same as other countries’. [My] girls were always coming to me saying that school officials had requested certain amounts of supplies from them and their families. … They asked for coal, gasoline, even rabbit skins. They told the students “We don’t care how you get it, just get it,” which meant they were telling them to steal of they had to.
Incredible as it is, this is speaking of the late 1990s, not ancient Sparta. North Korean unsustainability will eventually get the better of the situation. And the payoff will be huge and sustained if the trade is right.
The question is when. I believe it will be coming soon simply because Kim Jong-Un has no real support within the country. He grew up in Swiss private school in Berne, not shoulder-to-shoulder with cold-eyed cadres trained and nurtured on being utterly merciless. His father left a legacy that guarantees lasting hatred that would really enjoy tearing his son's face off. Thus his son must continue to be utterly ruthless just to survive.
His father, Kim Jong Il, was self-centered and lacked empathy. He viewed nearly everything and everyone in a utilitarian manner, and acted with a belief that lesser beings exist to serve him. He had no enduring commitments to principles other than that of his own self-interest. Kim thought of himself as a highly creative and artistic individual. Both Kim’s lack of empathy and sense of entitlement were revealed in his indulgent lifestyle, which contrasts with the struggle of most North Koreans to simply feed themselves. Defector reports indicated that Kim maintains lavish villas in each of North Korea’s provinces and has them furnished with imported luxury goods. He is the world’s leading importer of high-end cognac, according to a report carried by the Wall Street Journal in the mid-1990s, and has squads of beautiful female entertainers maintained for his benefit.
In contrast, saving lives has not been a top priority during North Korea’s famine. Early in the famine cycle Kim cut off nearly all food supplies to the four eastern provinces and denied these provinces access to international aid. Large numbers of deaths also occurred when, between 1997 and 1999 on Kim’s orders, several hundred thousand people displaced by the famine were herded into camps where conditions allowed few to survive. Moreover, according to the testimony of eyewitnesses, Kim Jong Il ordered the systematic killing of babies born in North Korea’s camps for political prisoners.
Late last year, his uncle and second-in-command either 1) attempted a coup or 2) was killed to further strengthen one of the shadowy factions jockeying for control of the regime. The epitaph at his execution read: “despicable human scum Jang, who was worse than a dog, perpetrated thrice-cursed acts of treachery in betrayal of such profound trust and warmest paternal love shown by the party and the leader for him.” This has apparently kicked off another purge cycle, as six senior Party officials were killed in late 2014. He has since turned his attention on the military, killing the Head of Army Operations was killed in January. This only serves to put an uneasy military with its back to the wall into more of a mood to summarily end the matter in their favor.
The question of when is one of the oldest problems of investing. It is equivalent to implementing a conviction view on an outcome when there is no clear sense of timing. In this case, Korean Unification is a long-run trend worth some positioning. The question is how to do it, given that 1) no one can tell exactly when (or if) it will happen and 2) the economy and financial markets are deeply coupled to the global economy. Getting the outcome right but the timing wrong is just another way of being wrong all over. It’s the common killer of the position trade.
The key is building a trade that is:
positive carry—to avoid the short JGB stupidities
idiosyncratic—offering exposure to unification
as uncorrelated as possible to other macro risks.
My trade is Korean Electric Power common stock. This is admittedly, outside of my comfort zone. South Korean debt is without doubt priced like a developed country at this point. About 46% of Korean government bonds are owned by overseas central banks, meaning they have safe harbor status. A bunch of price insensitive bond buyers have already skewed spreads down into crazy town. That is to say, there is little value in holding risky debt that offers little compensation for doing so.
Bonds (at least right now) violate trade rule #1. Further down the capital structure, bank equity is typically the only stock I ever look at. In this case South Korean bank equity is cheap, but it is not a unification trade—too correlated to other risk factors to be an appropriate waiting trade. Hence, Korean Electric power, (KEP on the NYSE, 015760: KS Bloomberg). It is stable, reasonably uncorrelated to inflation expectations and other Korean equities. It is generally priced relatively fair to its debt—not cheap, but it offers higher upside (and downside). Have a look.
The Model:
North Korea is arguably the worst place in the world, but even there, life still goes on. The society is still alive: A large ensemble of individuals interacting in a nontrivial fashion. No central command or dictate from the top down can specify every required action. Even this repressive system has “self-organized” outside of explicit instruction templates. Spontaneity is hard to kill, but every society needs a regular supply of energy, information, and/or matter from the environment to survive. In a crude but accurate way, Korea Electric Power offers a straightforward trade reflecting this. Electricity is a raw, material precondition for modernity.
Given these energies, new behaviors emerge from the system. When these behaviors arise from specific response to environmental pressure, we say the system displays adaptation. When adaptation reaches a number of scales—from households to businesses to military organizations, the system has evolved. Sometimes societies have to utterly collapse before they can move forward. When all the large, command-driven structures disintegrate, the basic building blocks remain and rebuild. These building blocks form new structures and the cycle can repeat.
So it doesn’t matter how bad the conditions become: life finds a way to reengineer. Whether life finds itself in a wasteland five miles down or a warm tropical coral reef, it finds a way. No one has to tell North Koreans that change is good. Change creates possibilities. Change shakes us out of our collective rut and shapes new modes of being.
Utopias are nowhere. That’s not what it takes to survive.