REITERATING OUR BEARISH BIAS ON THE KRW

Takeaway: Recent adjustments in monetary and fiscal policy strengthen our conviction on the short side of the South Korean won (KRW).

In line with our forecasts, South Korea posted its first sequential deceleration in headline GDP growth since 3Q12 last week and, underneath the hood, the data showed a fair degree of deterioration in domestic demand.

  • 2Q Real GDP: 3.6% YoY from 3.9%; 0.6% QoQ from 0.9%
  • Private Consumption: 1.5% YoY from 2.5%; -0.3% QoQ from 0.2%
  • Gross Capital Formation: 6.2% YoY from 4.3%; -0.1% QoQ from -0.9%
  • Government Consumption: 1.8% YoY from 2.9%; 0.4% QoQ from flat
  • Exports: 3.8% YoY from 4.5%; 1.9% QoQ from 1.5%
  • Imports: 2.4% YoY from 3.5%; 0.8% QoQ from -0.8%

Looking to the JUN and JUL growth figures, we see that the preponderance of South Korean economic data continues to show meaningful deterioration relative to their 3M, 6M and 12M trends. The negative deltas in PMI, BSI, retail sales, and export trends are some key things to focus on in the following table:

REITERATING OUR BEARISH BIAS ON THE KRW - SOUTH KOREA High Frequency GIP Data Monitor

In response to contracting consumption and investment, South Korean policymakers have ratcheted up support for the ailing economy in recent weeks. Key initiatives include:

  • Easing home loan restrictions: The Finance Ministry rolled back tightening measures first introduced in the mid-2000s by increasing the maximum loan-to-value ratio to 70% while also increasing the debt-to-income cap to 60%. While obviously a positive development for the South Korean housing market, this is likely to exacerbate what various South Korean officials publicly acknowledge as a debt bubble. For example, household debt as a % of disposable income is 163.8% in South Korea, which is well above the OECD average of 134.8%.
  • Introducing a multi-trillion won stimulus package: The government recently unveiled 11.7 trillion won in government spending initiatives while also directing state-backed lenders to extend 29 trillion won in credit. The BoK also stepped in by expanding a low-cost credit facility for SMEs to 15 trillion won from 12 trillion prior.
  • Rhetorical easing out of the “BoK”: While the BoK’s main policy rate has been on hold since a -25bps cut last MAY, Finance Minister Choi Kyung Hwan has really stepped up pressure upon the central bank to ease monetary policy by stating Friday that the two institutions share the view that the South Korean economy “needs quantitative easing”. That and his official view that the economy is in a “very difficult situation” have fueled an expectation among investors in the South Korean bond and interest rate markets that the BoK will be “forced” to resume cutting rates over the intermediate term, which is in line with our initial thesis. 2Y sovereign debt yields have come in -21bps MoM while 1Y OIS spreads have tightened -12bps MoM and are now in negative territory.

REITERATING OUR BEARISH BIAS ON THE KRW - 2Y Yields

REITERATING OUR BEARISH BIAS ON THE KRW - 1Y OIS

In spite of these efforts, we continue to see signs of negative momentum reverberating throughout the South Korean economy as highlighted above. As such, our GIP model still has South Korea mired in Quad #3 for the remainder of the year.

REITERATING OUR BEARISH BIAS ON THE KRW - SOUTH KOREA

Simply put, slowing momentum + a toughening base effect = a likely continued slowdown on the GDP front, while accelerating momentum  + a dissipating base effect + easier fiscal and monetary policy =a  likely continued acceleration on the CPI front. The growth data may start to surprise to the upside as we get into the fourth quarter, but we’re currently in wait-and-see mode with respect to the efficacy of the aforementioned stimulus efforts.

REITERATING OUR BEARISH BIAS ON THE KRW - MANUFACTURING PMI

REITERATING OUR BEARISH BIAS ON THE KRW - GDP COMPS

REITERATING OUR BEARISH BIAS ON THE KRW - CPI

REITERATING OUR BEARISH BIAS ON THE KRW - CPI COMPS

Our proprietary valuation models see 3-6% downside to fair value on a REER basis and 7-9% downside to fair value on a carry basis. As such, if you have capital allocated to South Korean financial markets, we strongly encourage you to think about hedging away that exposure to potential KRW weakness for at least the next 3-6M.

REITERATING OUR BEARISH BIAS ON THE KRW - FX REER VALUATION

REITERATING OUR BEARISH BIAS ON THE KRW - FX CARRY VALUATION

We say “at least” because the over-leveraged South Korean consumer economy coming unglued remains a key tail risk for investors to ponder over the long-term TAIL. On a consolidated basis, South Korea remains a relative safe-haven in the EM space, but that doesn’t mean it’s without its own unique set of key risks – namely the threat of a material downturn in the credit cycle.

REITERATING OUR BEARISH BIAS ON THE KRW - PILLAR III

REITERATING OUR BEARISH BIAS ON THE KRW - SUMMARY TABLE

REITERATING OUR BEARISH BIAS ON THE KRW - EXPLANATION TABLE

We introduced this thesis back on APR 28 and the KRW has edged up +0.8% vs. the USD since then, which is right in line with the average performance of the 21 currencies we track across Asia and Latin America. Will the -1.2% MoM decline be the start of the KRW unwinding its strong outperformance on a 1Y, 18M and 3Y basis? Stay tuned to find out…

REITERATING OUR BEARISH BIAS ON THE KRW - FX

Happy Monday,

DD

Darius Dale

Associate: Macro Team