Conclusion: With growth slowing and inflation accelerating in the Korean economy, Korean equities will present a nice opportunity on the short side over the intermediate-term TREND.
Position: Bearish on Korean equities.
By now, it should be clear that we don’t subscribe to Bernanke’s promise that equities will appreciate in perpetuity; nor do we buy the tired consensus argument that equities will continue to rise globally due to the “excess liquidity” created by QE2 (see: 2007). Cutting to the chase then, we have two very important questions regarding South Korea:
- Can the world’s 13th largest economy “comp the comps” with regard to YoY Real GDP growth?
- With inflation accelerating, will the Bank of Korea take the necessary steps to cool quickening price increases?
Notwithstanding that the former plays into the latter, as it stands currently, we don’t think Korea has enough mustard in the old engine to prevent growth from slowing domestically. Taken in the context of a) growth slowing globally; b) inflation accelerating globally; and c) interconnected risk compounding, it’s relatively easy to arrive at that conclusion considering that exports account for roughly ~50% of Korea’s GDP. China (21.5%), U.S. (10.9%), and Japan (6.6%) are its top three export markets and growth is slowing and/or setup to slow meaningfully in all three economies (growth in Japan could go negative over the next 2 quarters).
Looking at the table below, we see that Korea has some tough comps to surmount for the next three quarters starting in 4Q10:
On the inflation front, Korea has been reluctant to deal with its inflation woes, finally raising rates yesterday for only the second time this year. Unfortunately for Korea’s savers, the 25bps hike leaves the benchmark 7-Day Repo rate at 2.5% - a full 1.56% below the latest rate of consumer price inflation as measured by the October CPI report. In fact, real interest rates in Korea have been negative for nearly a full year, with the decline accelerating of late:
Clearly the negative real interest rates are helping stoke inflation as savers turn to consumers on the margin. With CPI accelerating to a 20-month high of +4.1% YoY and PPI accelerating to a 22-month high of +5% YoY, we see further rate hikes on the horizon as Korea is forced to combat rising prices. In fact, in concordance with yesterday’s rate hike, the Bank of Korea dropped its pledge to keep monetary policy “accommodative” for the first time since the financial crisis began. Instead, it shifted its tone towards “maintaining price stability while sustaining growth”.
While the CRB Commodities Index has backed off its recent highs, prices remain elevated enough on a YoY basis (+6.9%) to continue to quell inflationary pressures globally (thanks to Quantitative Guessing) and Korea is no exception, in spite of its reoccurring threats for capital controls. When it’s all said and done, Korea will likely have to institute a series of rate hikes that will further compound the problem alluded to in question #1 from above. When growth slows and inflation is accelerating, it’s not good for equities. Korean equity investors will find this out soon enough.
With the KOSPI up +12.9% YTD and up +9.7% since Bernanke started “shaking the ketchup bottle” at Jackson Hole, Korean equities have plenty of mean reversion to be had to the downside over the coming months.