Gravity Weighs on Korea

Conclusion: We see more selling pressure in the Kospi’s intermediate-term future, as the balance of earnings risk is skewed to the downside alongside the gravitational pull of mean reversion. Furthermore, the Bank of Korea will likely be more hawkish than is currently anticipated by consensus.

Today, the market didn’t like the Bank of Korea’s vigilance regarding its “war on inflation” (as proclaimed by president Lee Myung Bak in January). The latest +25bps move is the third rate hike YTD and brings the country’s real benchmark interest rate to -0.85%. While the recent slope of real rates is a noteworthy positive, we can’t help but callout the fact that Korean real rates (adjusted for inflation) have been in negative territory since November ’09. And while negative real rates have indeed been stimulative to Korean economic growth over the past couple of years, we can’t help but callout their negative impact on the future slope of growth in Korea – also negative.

Gravity Weighs on Korea - 1

Both Korea’s equity and bond market agree with our stance; the Kospi Index is now broken on an immediate-term TRADE and intermediate-term TREND perspective and Korea’s sovereign bond 10Y-2Y spread has narrowed -49bps YTD:

Gravity Weighs on Korea - 2

 

Gravity Weighs on Korea - 3

It seems that Global Macro is akin to real life in the sense that one cannot get something for nothing. What we mean by this is that Korea’s loose monetary policy has been bullish for domestic inflation readings and we expect Korea’s CPI to continue to accelerate on a YoY basis over the next 3-6 months – particularly its core inflation index. This will force the Bank of Korea to continue to tighten monetary policy – a direct blow to economic growth in the ~70% consumption-based economy (~55% Household; ~15% Government). Moreover, higher interest rates will weigh on private consumption going forward as servicing costs for an all-time high household debt burden of 801.4 trillion won ($740 billion; equivalent to 155.4% of disposable income) creep up.

Our view that the Bank of Korea will continue to remain hawkish over the intermediate term is divergent with current consensus expectations of only one more rate hike in 2011 to 3.5% (Bloomberg). We like being contrarian here, as the Bank of Korea has recently signaled that they’re on our side of the fence insomuch that they will look past slowing growth to continue on its path of interest rate normalization:

“The committee will conduct monetary policy with a greater emphasis on ensuring that the basis for price stability is firmly anchored while the economy continues its sound growth… Despite the temporary sluggishness of domestic demand, the economy has maintained its underlying upward trend.”

-Bank of Korea Governor Kim Choong Soo; June 10, 2011

Soo also said on May 18th that the Bank of Korea will continue to boost borrowing costs at its own pace and that the nation needs to be wary of an inflation spiral.

“Inflation spiral” and “sluggishness of domestic demand” isn’t exactly what investors in Korean equities want to be hearing out of the Korean central bank chief following a 26-month doubling of the Kospi Index. While the former is much less probable at the current juncture, that doesn’t change the fact that the latter is a real and present danger to Korean corporate earnings. As such, we see more selling pressure in the Kospi’s intermediate-term future. While Korea has been a darling over the last year (up +23.9% YoY), the balance of earnings risk is skewed to the downside alongside the gravitational pull of mean reversion.

Darius Dale

Analyst