Credit: Shutterstock photoBy Manning & Napier :
South Korea is a country which tends to get bounced back and forth between being thought of as an emerging market or a developed one, depending on who you talk to. While it is included as an emerging market country by MSCI in their Emerging Markets Index, we tend to think about South Korea as a developed country in terms of its investment risk profile, since it has many developed country characteristics. For example:
- South Korea is a mature, well established democracy with robust institutions and a solid emphasis on the rule of law.
- It is a technologically advanced and innovative economy with a diversified industrial base and fairly sophisticated financial system.
- It has relatively efficient capital markets and is home to several global champion companies.
- It has a healthy funding position, with a large surplus across the sum of its current account and fiscal balances, which is distinctly different from the "twin deficits" seen in many emerging market countries for this measure.
These characteristics, particularly the healthy funding position, are key considerations in the current market environment where global liquidity is in flux. To emphasize this point, consider the performance of emerging market currencies during the period from late May 2013, when the Fed announced its intention to "taper" its monthly asset purchases, through mid-September 2013 when it decided not to taper. Indeed, during this period, there was a strong relationship between twin deficits and currency depreciation. Countries running large twin deficits saw their currencies plunge, but South Korea, China, Taiwan, and a few others outperformed significantly, with the Korean Won actually appreciating almost 5% during the period. We believe that countries with large surpluses that do not rely heavily on funding from fickle foreign portfolio flows will continue to be relatively more resilient to changing market expectations of global liquidity.
Despite these strengths, South Korea faces some rather unique headwinds in the current global context. Korean wages have been growing in excess of productivity gains for almost two decades, leading to an increase in unit labor costs and a decline in the country's relative export competitiveness. This has been exacerbated by the unprecedented monetary experiment taking place in Japan, which has led to a substantial weakening of the Japanese Yen relative to the Korean Won. While Japanese export prices had shown surprising resiliency in the face of the decline in the Yen, that appears to be changing. In recent months, Japanese export prices have fallen on a year-over-year basis.
Given the similarities in the export profiles of Japan and South Korea, it is not surprising that Korean exporter prices have also begun to fall as the country attempts to defend market share. This is likely to continue to create margin pressure for Korean exporters, as the county's massive current account surplus and sizeable interest rate differentials versus U.S. rates have prevented a similar weakening of the Won relative to the U.S. Dollar, and therefore the Chinese Renminbi as well.
Not only does the Bank of Japan's meddling with market prices create a difficult and uncertain situation for Korean exporters, it also puts the Bank of Korea in a difficult position. Periods of Won appreciation versus the Yen have historically been deflationary for Korea. This places pressure on the Bank of Korea to continue to cut rates. However, South Korean consumers have one of the highest debt loads, measured as a percentage of disposable income or as a share of GDP, in the entire world, emerging and developed countries included. Given that the Bank of Korea's mandate was expanded a few years back to include increased responsibilities for financial stability, the continued debt buildup on the back of continuing rate cuts presents some concerns. In addition, Koreans have traditionally relied on variable rate mortgages and have a relatively high share of their household wealth tied up in real estate, leaving them vulnerable to a correction in housing. This makes the Bank of Korea especially keen to avoid a housing market downturn. Together, these factors limit the Bank of Korea's ability to respond to Japan's aggressive monetary policy and renders it a less formidable opponent in a currency war.
The competitiveness threats from Japanese currency weakness are certainly complicating Korea's outlook in the near and medium term from a margin standpoint and a monetary policy standpoint, but this is not the whole story in terms of the competitive threat. In fact, we believe that in the long run, the bigger threat will come from the west rather than the east of Korea. Despite all of its current economic concerns, China has continued to pressure Korea in categories which many would have thought impossible a decade ago. For example, we have witnessed China taking market share at the expense of Korea in everything from smartphones and consumer electronics to steel and shipbuilding. Indeed, if China is successful in opening and developing its capital markets and channeling capital toward more innovative and competitive companies, the competitive pressure on South Korea could very well intensify.
In summary, Korea is being squeezed from both sides - from a resurgent corporate Japan backed by an aggressive monetary policy on one side, and an ever more knowledgeable and capable corporate China on the other. We believe that all of these concerns have been reflected in the underperformance of the Korean market in a global context over the past year, despite the improving attractiveness of the overall market from a valuation standpoint.
Given the above conditions, we believe that from an investment standpoint, it is becoming increasingly prudent to look at South Korea very much the way we look at Japan. Both are countries which exhibit poor long-term demographics and poor domestic demand outlooks as far as the eye can see. While Japan's debt issues are on the government balance sheet and Korea's on the consumer side, both act as a headwind to strong demand. This places the onus for growth more squarely on export performance in an environment of internal competitiveness issues, weak global trade growth, and increasing competition from China. We think it is likely that Korea will follow Japan in the long run toward gradually relying more on the government balance sheet to support aggregate demand as the population ages and becomes more prone to saving.
From an investment standpoint, however, Korea is home to many extremely innovative companies which have shown they can capitalize on the relatively business-friendly and innovation-conducive operating environment at home, allowing them to enter and win in overseas markets. Moreover, the rise of the Chinese middle class is also likely to present some very favorable tailwinds for some smart Korean companies, particularly those that can leverage rising Chinese wealth and increased outbound travel to their advantage. This is the real story for South Korean companies, and it is why we still view the country as one of the most exciting markets out there, regardless of whether one prefers to call it emerging or developed.
See also Inflationary Expectations As A Predictor Of Actual Inflation on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
