Focus on Korean Fundamentals, Not Political Noise

new koreaPolitical tensions are likely to weigh on Korea from time to time, but the negative impact is typically fleeting.  Meanwhile, the economic fundamentals remain good.

POLITICAL OUTLOOK

Tensions on the Korean peninsula are likely to flare up again from time to time.  We expect periodic nuclear and missile tests, as North Korea continues its efforts to develop a missile and warhead that can reach the US.  So far this year, North Korea has conducted 14 ballistic missile tests and its technology appears to be advancing rapidly.

Diplomacy appears to be alive and well, however.  US Secretary of State Tillerson was in China over the weekend, where Pyongyang was reportedly a major topic of discussion.  Tillerson said that direct channels with Pyongyang remain open.  However, President Trump seemed to undercut him with subsequent remarks, saying Tillerson was “wasting his time.”

Whether this is basic “good cop, bad cop” or something deeper remains to be seen.  To us, acknowledgment of direct communications between North Korea and the US is a positive development.  The US has long hoped that China would be able to exert more influence on Pyongyang, while China has urged the US to negotiated directly with North Korea.

The next legislative elections are scheduled for April 2020.  It will be very important for Moon’s Minjoo party to build on its 2016 surprise victory (123 seats).  The conservative Liberal Korea Party (LKP and formerly the Saenuri party of impeached President Park) holds 107 seats in the 300-seat National Assembly, down from 122 that it won in 2016 after the Baruen party split off due to differences over the Park scandal.

President Moon was just elected in May to a 5-year term.  He won 41% of the vote, handily beating Hong of the LKP.  Under term limits, Moon cannot run again.  The National Assembly elections may provide important clues for the presidential election due in 2022.  Will voters flock back to the LKP and its tougher approach to Pyongyang?  Or will they favor the more open approach of Moon?

President Moon campaigned on improving North-South relations.  However, Kim’s belligerent actions have forced Moon’s hand.  For instance, Moon accepted full delivery and installation of the controversial THAAD missile defense system, after originally suspending the program.  His handling of the North Korean situation will likely be key to Moon’s reelection prospects.

Korea scores incredibly well in the World Bank’s Ease of Doing Business rankings (5 out of 190).  The best components are getting electricity and enforcing contracts, while the worst are getting credit and registering property.  Korea does less well in Transparency International’s Corruption Perceptions Index (52 out of 176 and tied with Kuwait, Tunisia, and Turkey).

Indeed, President Park’s impeachment shone a light on the country’s endemic corruption.  However, we are heartened by the fact that Samsung heir Lee was sentenced to 5 years in prison.  In the past, business leaders convicted of crimes have typically not been punished seriously.  Further structural reforms are needed, especially in corporate governance.

ECONOMIC OUTLOOK

The economy is still sluggish.  GDP growth is forecast by the IMF at 2.7% in 2017 vs. 2.8% in 2016, and is seen at 2.8% in 2018.  GDP rose 2.7% y/y in Q2, slowing from 2.9% in Q1.  The monthly data so far in Q3 is mixed, with IP and retail sales still soft while exports are picking up.  For now, the IMF forecasts appear to be on target.

Price pressures remain low, with CPI decelerating to 2.1% y/y in September from 2.6% in August.  Inflation is almost at the 2% target, while core inflation also eased to 1.6% y/y from 1.8% in August.  PPI rose 3.2% y/y in August, still elevated but down from the 4.4% peak in March.

We think the backdrop supports the case for steady rates.  The Bank of Korea has kept rates steady at 1.25% since its last 25 bp cut back in June 2016.  Next policy meeting is October 19, and no change is expected then.  Governor Lee has expressed concern about rising household debt, but we think this could be addressed with macroprudential policies rather than rate hikes.

Fiscal policy has remained prudent.  The budget surplus was 0.5% of GDP in 2016, up from balance in 2015.  The surplus is expected by the OECD to widen to around 2% of GDP in both 2017 and 2018.  This leaves fiscal stimulus as a viable option if the economy were to slow unexpectedly.

The external accounts remain strong.  Low oil prices and a sluggish economy have limited imports, while exports have been robust.  The 12-month trade surplus through September rose to a record high $98.1 bln.  The current account surplus was about 7% of GDP in 2016, and is expected by the IMF to narrow slightly to 6% in both 2017 and 2018.  We see upside risks to these forecasts.

Korea was the first to release September trade data.  It was a strong report, as exports rose 35% y/y and imports rose 22% y/y.  Indeed, recent trade data suggest that the regional economies are still doing well, despite signs of some slowing in mainland China in July and August.

The US is ratcheting up trade tensions with South Korea in the midst of heightened tensions with Pyongyang.  The US and South Korea will hold a second round of talks after the first one in August yielded little progress in amending the existing bilateral free trade agreement.  The US is Korea’s second largest export market, coming in behind China.

Foreign reserves have risen to new record highs.  At $385 bln in August, they cover nearly 8 months of import and are over 3 times larger than the stock of short-term external debt.  Coupled with a sizable current account surplus, Korea’s external vulnerability remains very low.

INVESTMENT OUTLOOK

The won has done much better after a subpar 2016.  In 2016, KRW fell -3% vs. USD and was ahead of only the worst performers ARS (-18%), TRY (-17%), MXN (-16%), CNY (-6.5%), PHP (-5%), and MYR (-4%).  So far in 2017, KRW is up 5.5% and is amongst the top EM performers.  The best are MXN (13.5%), THB (7%), CLP (6%), SGD (6%), RUB (6%), and MYR (6%).  Our EM FX model shows the won to have VERY STRONG fundamentals, so this year’s outperformance is likely to continue.

Since March, USD/KRW had traded largely in the 1110-1160 range.  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 1139 currently.  Lastly, the key JPY/KRW cross remains above 10, which is where Korean exporters prefer it remains.

Korean equities are underperforming EM after a solid 2016.  In 2016, MSCI Korea rose 10% vs. 7% for MSCI EM.  So far this year, MSCI Korea is up 25% YTD and compares to 28% YTD for MSCI EM.  This modest underperformance should ebb, as our EM Equity model has Korea at a VERY OVERWEIGHT position.

Korean bonds have underperformed this year.  The yield on 10-year local currency government bonds is about +31 bp YTD.  This trails only the worst EM performer Czech Republic (+96 bp) and China (+61 bp).  With inflation likely to remain low and the central bank likely to remain on hold for now, we think Korean bonds will start outperforming more.

Our own sovereign ratings model showed Korea’s implied rating steady at AA-/Aa3/AA- after falling a notch last quarter.  As such, Korea still faces some downgrade risks to S&P’s AA and Moody’s Aa2 ratings.  Fitch’s AA- appears to be on target.