Korea’s Strong Fundamentals Point to Continued Outperformance

Korea is likely to remain under pressure along with the rest of the Emerging Markets, however, strong fundamentals support our view that Korean assets are likely to outperform.

INTRODUCTION

Korea is likely to remain under pressure along with the rest of the Emerging Markets. However, strong fundamentals support our view that Korean assets are likely to outperform within EM. Indeed, our EM FX and EM Equity models both point to Korea as an outperformer in Q3.

POLITICAL OUTLOOK

The popularity of President Park has been hurt by the Middle East Respiratory Syndrome (MERS) outbreak, which many feel was mishandled. The sluggish economy is also likely weighing on her appeal. Her term runs until early 2018. Ahead of the December 2017 presidential election, parliamentary elections will be held in April 2016. If her Saenuri Party loses those elections, President Park will most likely become a lame duck.

The geopolitical side has been relatively quiet. There have been no major flare-ups with North Korea and there are some tentative signs of approximation with Chinese and Japanese leaders regarding the disputed territories in the South China Sea. There may even be some attempts to revive talks about the dispute that stalled in 2012 via a summit later this year.

ECONOMIC OUTLOOK

The risks from MERS appear to be ebbing, and should have little lasting impact on the economy. After reported cases peaked in mid-June, there have been no confirmed cases since July 4. Press is reporting that the authorities may declare an end to the outbreak on August 2 if no additional cases are confirmed. Consumer confidence fell in June, but we suspect it will rebound in July and August as MERS retreats.

The BOK just left rates steady at 1.5% last week. CPI rose 0.7%y/y in June, well below the 2.5-3.5% target. Despite its more hawkish stance of late, we think the BOK will be forced back into a more dovish stance as the economy weakens.

On the fiscal side, the government has already implemented some stimulus measures. Earlier in the month, Korea announced a $20 bln fiscal stimulus package to counteract the economic impact of the virus. The budget has been in surplus since 2010, giving the government leeway to boost spending this year.

Still, the economy is clearly slowing, with y/y growth falling for four straight quarters through Q1. The BOK recently cut its growth forecast for 2015 to 2.8%, but this still seems too optimistic. GDP rose 2.5% in Q1, and we believe signs point to further slowing in Q2 rather than the consensus 2.8%. Singapore reported much weaker than expected Q2 GDP growth this week, and points to downside risks for regional growth ahead.

Korea’s external accounts continue to improve, though largely led by a fall in imports. Imports contracted -13.6% y/y in June. Still, the trend has helped support the won. The current account surplus is likely to rise to around 7% of GDP this year from around 6% in 2013 and 2014.

INVESTMENT OUTLOOK

USD/KRW traded at a two-year high today, and we believe further won weakness is desirable for Korean policymakers. Long-term charts point to a test of the 2013 high near 1163, then the 2012 high near 1185, and then the 2011 high near 1208. The important JPY/KRW cross has been trending higher as well, and that will help Korean exporters regain some competitiveness. While we see continued won weakness, we stress that our EM FX model taps Korea to outperform within EM over the next three months.

Korean stocks have outperformed within EM this year, with MSCI Korea at -1.7%. This compares with a -2.0% performance for MSCI EM. We note that our EM equity model also taps Korea to outperform within EM over the next three months. Indeed, Korea is the highest scoring market in our model for Q3.

Korean bonds have outperformed over the last three months, with 10-year yields up around 44 bp from the April low near 2.06%. This compares to a 55 bp rise in the US 10-year yield for the same period. Other EM bond markets have been hit much harder from the curve steepening in the Developed Markets. We believe a combination of low inflation, sluggish growth, and potential BOK easing will help boost Korean bonds in Q3.