The South Korean stock market is highly sensitive to global macro conditions and has fared worse than some other emerging markets this year. This underperformance is tied to its export-oriented economy—which impacts gross domestic product growth (GDP) for better or worse—and its high sensitivity to US interest rates, which have been rising sharply.
The backdrop of large US rate hikes, slowing global growth leading to recession concerns, and elevated oil prices have led to severe weakness in South Korea’s currency, the won. We believe broader equity market and currency weakness are likely to remain as long as the US interest-rate cycle remains on an upward trend and global growth concerns persist.
From a macro perspective, 2022 continues to be challenging, and there is risk of continued downward pressure on the won. However, a weaker won is a tailwind for South Korean exporters, as it enhances their competitiveness relative to peers, which we think leads to meaningful bottom-up stock picking opportunities.
As we look ahead into 2023, we believe normalization of interest rates and improvement in global growth could lead to an improvement in the South Korean stock market. From a macro perspective, it seems feasible that South Korea can achieve a stable 2.5% GDP growth, with low unemployment rates and less-sticky inflationary conditions.
Currency issues and exports
The weak won is a function of South Korea’s widening trade deficit, the product of weakening exports (such as semiconductors) and the global rise in energy costs given the country’s status as a net energy importer. We think that the trade balance can recover and potentially turn into a surplus in 2023 if oil prices keep declining and global growth recovers.
South Korea is an export-oriented economy and thus geared toward global growth but has some distinct characteristics that make it unique compared to other markets in Asia.
Chaebols, which are large, family-run conglomerates, control large portions of the economy. Chaebols typically have defensive balance sheets. During the 1998 financial crisis, the chaebols were very cautious in managing financial stability. In this current period of volatility, most chaebol companies are now in a net cash position. This implies that there is very limited solvency and liquidity risk for a large percentage of the South Korean stock market.
Compared to other Asian markets such as China, India and Southeast Asia, South Korea has relatively fewer domestic investment opportunities given the smaller total addressable market, higher existing GDP per capita, and its demographics, as the country faces an aging and shrinking population. Thus, there is limited scope for increased market penetration and/or consumer upgrading.
From a bottom-up stock picking perspective, we are thus relatively more positive on export-oriented opportunities, such as the electric vehicle (EV) battery supply chain.
Expectations of a slowdown in global growth have certainly had an impact on South Korea’s market. If the global economic outlook improves, we expect key South Korean industries such as memory, EV battery and autos to see improved performance due to a strong structural growth outlook and competitive positioning within their respective industries. Current geopolitical uncertainty might also benefit South Korean companies in those same industries, with the potential to gain share in the United States in particular.
Supply chain diversification
The passage of the US Inflation Reduction Act has broader implications regarding the diversification of supply chains away from China, which we think could potentially benefit South Korea. In our view, there is more scope for South Korean players to gain market share in the United States relative to Chinese players, and US regulation related to technology transfer makes it significantly more challenging for Chinese companies to compete on the cutting edge in key industries such as semiconductors (i.e., the US export restrictions on ASML’s extreme ultraviolet [EUV] systems to China). It is notable that several prominent South Korean companies are seeking to accelerate capacity construction in the United States post the Inflation Reduction Act. There is currently a lack of clarity in its regulation and implementation, but there is leeway for South Korean companies to become eligible for Act-related subsidies by converting their existing capacity footprint.
We view the Inflation Reduction Act as highly supportive of electrification of mobility. The tax benefits to consumers and manufacturers are to spur investment in the United States, enhance localization, and to encourage EV adoption. There isn’t a ban on materials sourced from and/or refined in China. Indeed, the United States recognizes that a sizeable portion of critical minerals are sourced from China, but the United States would prefer a greater degree of localization, and as such, the government is likely to implement a system with a phased minimum content requirement in order to be eligible for the tax credits.
The South Korean players in the EV battery supply chain continue to pursue opportunities to diversify their sourcing from Chinese suppliers, with varying degrees of success. For example, recycling is an area where South Korea, with extensive experience in battery handling, should see an advantage in the medium to longer term. With regards to the South Korea players in the EV supply chain, we view the Act as positive because it signals a serious intention of the United States to accelerate both adoption and manufacturing of electric vehicles onshore. Korean companies should enjoy substantial first-mover advantage in the US and North American markets.
The “Korea discount”
South Korea’s market has seen sizable foreign outflows over the past year and a half, as it is very exposed to global market dynamics. The country’s exports are often thought to be a forward-looking indicator of the global economy. As such, we expect the equity market to recover as global market dynamics improve. From a bottom-up perspective, we think there is significant scope for stock picking in export-orientated structural growth opportunities.
The market has suffered from a phenomenon called the “Korea discount,” where valuations of listed companies in South Korea lag that of their peers. In our view, the reason for the lag is tied to corporate governance and capital allocation.
In recent years, companies have started to focus more attention on minority shareholders and pay increased dividends. However, we believe more action is required for the discount to narrow. The new administration under President Yoon Suk-yeol is cognizant of this corporate governance discount, and we remain hopeful that things will continue to improve, with the help of new regulations.
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