Strong Korean Fundamentals Should Outweigh Political Risks

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News of ballistic missile launches by North Korea over the weekend adds to an already tense situation on the Korean peninsula. Yet South Korea’s strong fundamentals suggest it will remain resilient in the face of recent political developments.

POLITICAL OUTLOOK

Markets were rattled by news of North Korea missile launches over the weekend.   Four ballistic missiles were reportedly fired into the waters surrounding Japan. Coming so soon after the assassination of Kim Jong-Un’s half-brother in Malaysia, recent actions by Pyongyang are getting more erratic and unpredictable. Yet Korean markets typically shrug off any selling pressures due to Pyongyang’s actions.

The missile launches would seem to validate the planned deployment of the Terminal High Altitude Area Defense (THAAD) system. While the missile defense system is in response to threats from North Korea, China is unhappy with the deployment because it breaks “the strategic equilibrium in the region.” Chinas’ Foreign Ministry recently said it is “highly concerned” about the military drills being carried out by the US and South Korea.

China condemned the weekend launches, but it remains to be seen if it will take stronger action to rein in its client state. Here, some signs are encouraging. Last month, Beijing suspended coal imports from North Korea until the end of this year to show its displeasure with Pyongyang’s recent actions. Virtually all of North Korea’s exports go to China, and about 40% of those shipments are coal and minerals.

Before the weekend, Korean press reported that China has told its travel agents to halt sales of holiday packages to South Korea. Spokesman for China’s Foreign Ministry said he wasn’t aware of any such measures while an official at the Korea Tourism Organization (KTO) said China has issued the ban. KTO estimates that nearly half of the foreign visitors to Korea last year were from China.

Domestic political uncertainty remains in play as the impeachment of President Park continues. The Constitutional Court is currently examining the impeachment motion brought by Parliament. Prime Minister Hwang is acting president during the 180 day period of examination that started December 9.

Our base case is that Park is legally removed from office. If so, then a new election would be held before the regularly scheduled one for December of this year. If she is reinstated, this would be very negative for Korea. We believe it would usher in a period of political instability and protests that could further harm the economic outlook.

Meanwhile, the scandal has had unintended consequences. A Korean special prosecutor indicted Samsung chief Jay Y. Lee on bribery charges. He is accused of exchanging bribes for government favors, which were uncovered during the investigation of President Park. Lee allegedly directed tens of millions of dollars to a confidante of President Park in return for government support of a 2015 merger that benefited his interests.

ECONOMIC OUTLOOK

The economy is recovering. GDP growth is forecast at 2.5% in 2017 vs. 2.7% in 2016, and then recovering to 2.6% in 2018. GDP rose 2.3% y/y in Q4, the lowest since Q2 2015. Downside risks are present due to the possible travel ban by China as well as ongoing political uncertainty stemming from the presidential corruption scandal. Consumer confidence is at multi-year lows at the start of 2017.

Price pressures are rising, with CPI rising 1.9% y/y in February vs. the cycle high of 2.0% y/y in January. That was the highest rate since October 2012, and was right at the bank’s 2% target. Low base effects should push inflation well above target in the coming months. This supports the case for a more hawkish BOK stance in 2017, though downside risks to growth are likely to keep rates on hold in H1. The central bank last cut rates 25 bp to 1.25% in June 2016 but has been on hold since. Next policy meeting is April 13, no change seen then.

Fiscal policy has remained prudent. The budget surplus came in at an estimated 0.5% of GDP in 2016, slightly better than the balanced budget in 2015. The surplus is expected to come in around 0.3% in both 2017 and 2018. Fiscal stimulus is likely if the economic outlook worsens.

The external accounts remain strong. While the slowing mainland China economy hurt exports, low energy prices and the sluggish economy helped reduce imports. The current account surplus was over 7% of GDP in both 2015 and 2016, and is expected to narrow slightly to 6.1% in 2017 and 5.5% in 2018.

Foreign reserves stood at $374 bln in February, which is near the all-time highs. They cover nearly 9.5 months of import and are almost 4 times larger than the stock of its short-term external debt.

INVESTMENT OUTLOOK

The won has outperformed after a mediocre 2016. In 2016, KRW fell -3% vs. USD and was in the middle of the EM pack. So far in 2017, KRW is up 4% YTD and is behind only the best EM performer MXN (+65), ZAR (+6%), RUB (+6%), and BRL (+4%). Our EM FX model shows the won to have STRONG fundamentals, so this year’s outperformance is to be expected.

USD/KRW retraced the entire post-election rise before reversing. Using the December-February drop, the major retracement objectives come in near 1160 (38%), 1170 (50%), and 1180 (62%). The 200-day MA comes in near 1148.

The key JPY/KRW has been hovering near the 10 level, which many exporters view as key for competitiveness. Yen weakness since November has pushed this cross down from over 11 in Q3.

Korean equities are underperforming after a strong 2016. In 2016, MSCI Korea was up 10% vs. 7% for MSCI EM. So far this year, MSCI Korea is up 4% YTD and compares to 9% YTD for MSCI EM. This underperformance should ebb, as our EM Equity model has Korea at a VERY OVERWEIGHT position.

Korean bonds have underperformed recently. The yield on 10-year local currency government bonds is +14 bp YTD. This compares to the worst performers China (+34 bp), India (+33 bp), and Hungary (+27 bp). With inflation likely to continue rising and the central bank likely to lean more hawkish this year, we think Korean bonds will continue underperforming.

Our own sovereign ratings model shows Korea’s implied rating at AA/Aa2/AA. As such, we believe actual ratings of AA/Aa2/AA- are more or less on target.