FXStreet (Delhi) – Research Team at BBH, suggests that the atomic test by the North has kept markets jittery regarding the Korean peninsula but based on strong fundamentals enjoyed by the South, they think South Korean assets are likely to continue outperforming. Key Quotes “Political Outlook Tensions have risen on news that North Korea detonated some sort of nuclear weapon this week. Pyongyang claims it was a hydrogen bomb, but many analysts are skeptical that it has the wherewithal to produce this more powerful version. While the long-term investment implications are likely to be limited (as Pyongyang’s previous nuclear tests have proven), the short-term impact will likely keep markets extra jittery. Before this, relations between the North and the South had appeared to be improving. Clearly, this will set things back a bit. However, we believe that the bomb test is just the latest of Pyongyang’s seemingly annual saber-rattling exercises. Parliamentary elections will be held in April. Polls suggest the ruling Saenuri Party (formerly the Grand National Party) will win another majority. President Park Geun-hye of Saenuri was elected in 2013 with 52% of the vote but then saw her popularity fall. It has recently been rising, and a tough stance against the North could boost her even further. The next presidential election will be held December 2017, and President Park cannot run again under constitutional rules. It’s too early to say who her likely replacement will be. Economic Outlook The economy is picking up a bit, but remains sluggish by historical standards. GDP rose 2.7% y/y in Q3, up from the 2.2% trough in Q2. Growth was likely around 2.7% in 2015, but is forecast by the IMF to improve to 3.2% in 2016 and 3.7% in 2017. This is slightly stronger than private sector consensus forecasts for the next two years of 2.9% and 3.1%, respectively. Price pressures remain low but are picking up. CPI rose 1.3% y/y in December. This is the highest rate since August 2014, and suggests limited room for further easing. Indeed, core CPI rose 2.4% y/y in both November and December, a cycle high. The Bank of Korea has been on hold since the last 25 bp cut to 1.5% in June 2015. Incoming Finance Minister Yoo has pledged to continue the administration’s current economic policies. President Park recently called for more measures to boost the economy, so we’d expect some more fiscal stimulus in 2016 from Yoo. Indeed, fiscal policy has been the main lever of stimulus in recent months. Yet the budget has only moved to balance in 2015 from regular surpluses around 1% of GDP since 2010. Modest surpluses are forecast for both 2016 and 2017, though there is some modest downside risk from a soft economy. The external accounts are in very strong shape. Lower oil prices and the slow economy have reduced imports, and this has outweighed the downward pressure on exports. The current account surplus is forecast by the IMF at 7% for both 2015 and 2016, rising from 6% in both 2013 and 2014. Foreign reserves remain high at around $368 bln. One of the main beneficiaries of recent yen strength is Korea. The key yen/won cross has moved above the important 10 level for the first time since September. It could test the August high near 10.30, especially if the won sees some catch-up weakness as EM sentiment remains sour. This would help Korean exporters at the margin, who have gotten squeezed by the weak yen. Investment Outlook The won has been one of the better EM performers. Over the past twelve months, KRW has lost only 6% vs. USD. Only TWD, CNY, INR, and PHP have done better over that same period. Our EM FX model shows the won to have strong fundamentals, and so we think its outperformance will continue in 2016. That said, USD/KRW is likely to test the 2010 high near 1278 in the coming weeks. Retracement objectives from the big 2009-2014 drop come in near 1233 (38%), 1303 (50%), and 1372 (62%). Korean equities have outperformed within EM. MSCI Korea is down -2.9% YTD, and compares to -4.9% YTD for MSCI EM. For all of 2015, MSCI Korea was down only -2.3% vs. -16.6% for MSCI EM. This outperformance should continue in 2016, as our EM Equity model has Korea at the top of our league chart with a VERY OVERWEIGHT position. Korean bonds have done well. Over the past twelve months, the yield on 10-year local currency government bonds is down -54 bp. This is well in the outperforming camp. Compare this to the worst performers Brazil (+368 bp), Turkey (+334 bp), Peru (+190 bp), and South Africa (+178 bp). Only a handful has done better than Korea: Russia (-324 bp), China (-77 bp), and Bulgaria (-64 bp). With inflation likely to rise and the chances rather low for further BOK easing, however, we think Korean bonds could start underperforming a bit more.” For more information, read our latest forex news.