South Korea Goes to the Polls

New Korea

Korea will vote Tuesday for the next president to replace impeached Park Geun-hye.  Moon Jae-in is the frontrunner and would herald a change from nine years of conservative rule, which could upend North-south relations as well as the role of the chaebol. POLITICAL OUTLOOK

The center-left candidate Moon Jae-in is poised to win.  Latest Gallup poll suggests he will get 40% of the vote.  Ahn Cheol-soo (24% support) of the People’s Party (a spinoff from Minjoo) and Hong Joon-pyo (12% support) of the Liberal Korea Party (formerly Park’s Saenuri Party) are the other major contenders.

It’s worth noting that despite a resounding victory last year, Moon’s Minjoo party lacks a working majority in parliament.  Fresh elections won’t be held until 2020, so there is a risk of some gridlock.  A best-case scenario would have Minjoo supported by its spinoff People’s Party, which would give them a working majority in the 300-seat parliament.   However, relations between the two remain strained.

In the April 2016 parliamentary election, Minjoo won 123 seats, up from 102 previously.  Saenuri was punished by the voters, winning only 122 seats vs. 146 previously.  The People’s Party won 38 seats while the progressive Justice Party won 6 seats.  Saenuri has since split due to differences over supporting Park into the Liberal Korea Party and the Bareun Party.

Relations with North Korea will be the major focus for the next government.  Moon has signaled he will take a less confrontational approach with Pyongyang.  Many Korean’s saw North-South relations worsen despite Park’s hardline approach, and so a softer touch may be needed.  The early deployment of the controversial THAAD missile defense system will complicate matters for Moon.

How the next president deals with the chaebol conglomerates will also be closely watched.  After all, it was the bribery scandal with Samsung that brought down Park, and the old way of doing business has come under increasing scrutiny.  While Korea scores very well in the World Bank’s Ease of Doing Business rankings (5 out of 190), it does less so in Transparency International’s Corruption Perceptions Index (52 out of 176).

ECONOMIC OUTLOOK

The economy is still sluggish.  GDP growth is forecast by the OECD to decelerate modestly to 2.6% in 2017 from 2.8% in 2016, before picking up to 3% in 2018.  GDP rose 2.3% y/y in Q4, the slowest since Q2 2015.  Monthly data so far show in Q1 suggest some acceleration.  However, China’s economy appears to be softening and so we believe there are some downside risks to the growth forecasts.

Price pressures bear watching, with CPI decelerating to 1.9% y/y in April from 2.2% in March.  That was the highest rate since June 2012, but inflation remains near the 2% target.  This supports the case for steady rates for the time being, though low base effects suggest inflation will accelerate in the coming months and may necessitate a more hawkish stance.  The Bank of Korea next meets May 25, no change is seen then.  The central bank last cut rates 25 bp to 1.25% in June 2016 but has been on hold since.

Fiscal policy has remained prudent.  Korea has generally avoided running deficits since the Asian crisis.  The budget surplus came in at an estimated 0.5% of GDP in 2016, little changed from 2015.  It is expected by the OECD to rise to 2.5% of GDP in both 2017 and 2018.  We believe the next government may rely on fiscal stimulus if growth remains sluggish.

The external accounts remain very strong.  Slower growth in China has hurt exports, but low energy prices and the sluggish economy have helped reduce imports.  The current account surplus was about 7% of GDP in 2016, and is expected to narrow slightly to 6% in both 2017 and 2018.  Foreign reserves have remained fairly steady and at $376.6 bln in April, they cover nearly 8 months of import and are 3 ½ times larger than the stock of short-term external debt.

INVESTMENT OUTLOOK

The won has done better after a so-so 2016.  In 2016, KRW fell -3% vs. USD and was in the middle of the EM pack.  Best performer last year were BRL (+22%), RUB (+20%), and ZAR (+13%), while the worst were ARS (-18%), TRY (-17%), and MXN (-16%).  So far in 2017, KRW is up nearly 7% YTD and is behind only the best performers MXN (+9%) and TWD (+7%).  Our EM FX model shows the won to have STRONG fundamentals, so this year’s outperformance is to be expected.

USD/KRW has traded in a narrow 1110-1160 since the end of January.  Retracement objectives from the December-March drop come in near 1149 (38%), 1161 (50%), and 1173 (62%), while the 200-day moving average comes in near 1143 currently.  The key JPY/KRW cross has been flirting with the key 10 level that Korean exporters favor.

Korean equities continue to outperform.  In 2016, MSCI Korea was up 10% vs. 7% for MSCI EM.  So far this year, MSCI Korea is up 16% YTD and compares to 15% YTD for MSCI EM.  This slight outperformance should intensify, 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 about +16 bp YTD.  This is ahead of only the worst performers China (+58 bp), India (+42 bp), Romania (+39 bp), and Czech Republic (+19 bp).  With inflation likely to continue rising and the central bank perhaps tilting more hawkish, we think Korean bonds will continue underperforming.

Our own sovereign ratings model showed Korea’s implied rating fell a notch to AA-/Aa3/AA- this quarter.  As such, Korea may face some growing downgrade risks to S&P’s AA and Moody’s Aa2 ratings.  Fitch’s AA- appears to be on target.