Korean Outperformance Supported by Strong Fundamentals

RO-26

Korea continues to outperform within EM, due largely to strong underlying fundamentals. We believe this outperformance will continue.

POLITICAL OUTLOOK

President Park Geun-hye’s 5-year term ends in early 2018, and she can only serve one term. Her successor will be chosen in the December 2017 election. She risks being a lame duck after her ruling Saenuri party did poorly in the April 2016 parliamentary elections, winning only 122 seats. Chairman Kim Moo-sung and other party leaders resigned as a result, so it is not yet clear who their likely candidate will be next year.

The opposition Minjoo party won the most seats (123) but fell short of a majority in the 300-seat parliament. The two other major parties are the centrist People’s Party (38 seats) and the leftist Justice Party (6 seats). There has been some speculation that UN Secretary General Ban Ki-moon might run after his term ends in 2016. He served as Foreign Minister under President Roh Moo-hyun.

President Park came to power with a conciliatory stance towards Pyongyang. However, relations with North Korea have soured, but through no fault of her own. Bomb and missile testing early this year by Pyongyang forced her to take a more hardline stance, as Kim Jong-un has been very belligerent towards the South since taking over for his father Kim Jong-Il in 2012.

The US and South Korea recently agreed to deploy an advanced US missile defense system in response to the growing threats from the North. Furthermore, the US Treasury imposed financial sanctions on Kim Jong-Un for the first time. Most importantly, China appears to have turned a corner with regards to North Korea. Earlier this year, Beijing supported UN Security Council sanctions that were enacted after the weapons testing.

ECONOMIC OUTLOOK

The economy remains sluggish. GDP growth is forecast to accelerate modestly to around 2.7% in 2016 and 2.9% in 2017 from 2.6% in 2015. GDP rose 3.2% y/y in Q2. This was slightly firmer than expected, and was boosted by a low basis for comparison. Base effects for the rest of the year are higher and less favorable for y/y comparisons, however.

China is the biggest export destination for Korea, and annual exports there are nearly triple those to the next biggest market (the US). Studies suggest that much of those exports to China are intermediate goods meant for the manufacturing sector. As such, continued slowing in the mainland economy is a big headwind for Korea.

Price pressures are still low, with CPI rising 0.7% y/y in July. This is the lowest rate since September 2015, and remains well below the 2.5-3.5% target range. This supports our view that more easing will be seen. Bank of Korea meets this Thursday and is expected to keep rates steady at 1.5%. We do not think the 25 bp rate cut in June was “one and done” and so there is a risk of a dovish surprise here.

Fiscal policy has remained prudent. The budget was close to balance in 2015. This year, it is expected to go into a modest deficit as the government focuses on fiscal stimulus to help boost growth. Because of years of budgetary restraint, the government has a fair amount of leeway to use expansionary fiscal policy without endangering the fiscal outlook.

The external accounts remain strong. Slow global growth has hurt exports, but low energy prices and slow growth have helped reduce imports. The current account surplus was about 8% of GDP in 2015, and is expected to remain near there in both 2016 and 2017. Foreign reserves have remained near record highs. At $371.4 bln in July, they cover over 9 months of import and are about 3.5 times larger than short-term external debt. Korea’s external vulnerabilities are quite low.

INVESTMENT OUTLOOK

The won has generally outperformed within EM. In 2015, KRW lost -6% vs. USD. This trailed only the best performers TWD (-4%), CNY (-4%), INR (-5%), and PHP (-5%). So far this year, KRW is up 6% YTD and is lagging only the best performers BRL (+25%), RUB (+14%), ZAR (+14%), CLP (+8%), MYR (+6%), and COP (+6%). Our EM FX model shows the won to have VERY STRONG fundamentals, so this year’s outperformance is to be expected.

USD/KRW is making new lows in August, trading at levels not seen since mid-2015. Break below the June 2015 low near 1100 would set up a test of the April 2015 low near 1065.

Korean equities have underperformed this year after outperforming in 2015. Last year, MSCI Korea was -2% while MSCI EM was -17%. So far in 2016, MSCI Korea is up 6% YTD and compares to +12% YTD for MSCI EM. This underperformance should ebb a bit, as our EM Equity model has Korea at a VERY OVERWEIGHT position.

Korean bonds have outperformed this year. The yield on 10-year local currency government bonds is about -65 bp YTD. This is behind only Brazil (-465 bp), Indonesia (-183 bp), Russia (-127 bp), South Africa (-120 bp), Colombia (-102 bp), and Turkey (-96 bp) and. With inflation likely to remain low and the central bank likely to cut again, we think Korean bonds will continue outperforming.

S&P just upgraded Korea a notch to AA with a stable outlook. This is right where our own ratings model puts it. The move also matches Moody’s, which upgraded Korea to Aa2 back in December. Fitch now lags with its AA- rating.