South Korea: Downgrade to 3.5 Stars “Attractive” as trade headwinds mount, outlook darkens

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• South Korea’s export-led recovery is showing signs of reversing after the country, which historically runs a trade surplus, experienced six straight months of deficits. 

• Korea’s manufacturing PMI contracted for the third straight month in September (47.3). New export orders and production fell sharply as fears of an economic downturn weigh on demand.

• The KOSPI’s heavy exposure to cyclical sectors and the downturn in the semiconductor industry are likely to weigh on earnings growth in the near-term.  

• In light of these developments, we have decided to downgrade South Korea by one notch to a rating of 3.5 Stars “Attractive”. 

Similar to other North Asian economies, South Korea got off to a bumpy start this year. As inflation raged across most developed markets, central banks have been rushing to raise interest rates, causing the global economy to slow. As a result of the slowing economic growth, export-oriented economies have taken a hit, including South Korea, with the KOSPI falling more than 20% year-to-date (Figure 1). 

Figure 1: The KOSPI has fallen more than 20% this year as the global economy slows 

Looking ahead, we foresee tougher times for Korean equities as the nation’s export-led recovery is showing signs of reversing. In addition, with inflation and interest rates likely to stay higher for longer, domestic consumption is starting to slow, adding to the country’s woes. As such, we have decided to downgrade the market to a rating of 3.5 Stars “Attractive”, from our previous rating of 4 Stars “Very Attractive”. 

South Korea’s export-led recovery is showing signs of reversing

As an export-oriented economy, Korea is more sensitive to changes in the external environment. Exports, which account for roughly 40% of GDP, rose 25.7% year-over-year in 2021, and were responsible for more than half of Korea’s 4% GDP growth that year. Coming into 2022, the export-led recovery that it has enjoyed since mid-2020 is starting to reverse, dimming the outlook for the Korean economy. 

Korea, which historically runs a trade surplus recorded six straight months of deficits (its longest run in more than two decades) after the trade balance came in at USD -3.8 billion in September (Figure 2). One reason that can explain the string of deficits is the fact that imports jumped by nearly 20% year-over-year on the back of higher energy prices. Meanwhile, export growth has been faltering, falling from a peak of 45.5% in May 2021 to just a paltry 2.2% in September 2022, marking the fourth consecutive month of single-digit export growth as global demand wanes. 

Figure 2: Korea posted its largest ever trade deficit in August this year 

Among Korea’s trading partners, it should not come as a surprise that China, the world’s second largest economy (and one of its closest neighbours), is the main destination for Korean exports, accounting for nearly 30% of outbound trade. 

Since the year 2000, Korea has always held a trade surplus with China. But that relationship has changed as of late after it recorded a deficit for three consecutive months since May, a worrying trend should it persist. As a matter of fact, exports to China have shown little growth since 2012, hovering around the USD 12 billion mark for the most part. This was partly due to souring relations between China and Korea following the deployment of the THAAD anti-missile system, as well as China’s push towards self-reliance. 

Figure 3: For the first time since the year 2000 Korea now runs a trade deficit with China 

Today, China’s economy has been teetering as it faces a host of challenges, such as a property crisis and renewed outbreaks of COVID-19. The government’s reluctance to deviate from its Covid-zero policy and its willingness to use lockdowns to stop the spread of the virus have also added pressure to its economy. Using the Shanghai lockdowns as a precedent, such large-scale lockdowns are extremely disruptive to both economic and consumption activity, which may take some time to recover even after the restrictions are lifted.  

To make things worse, China has signalled that it may miss its annual economic growth target of 5.5%, indicating that the target merely serves as a guidance, rather than a hard target. Given Korea’s heavy reliance on China for trade, an economic slowdown in the latter will surely affect the outlook of Korea. 

The weakening trade outlook is already taking a toll on Korea’s economy. September’s manufacturing PMI showed a contraction for the third straight month (47.3), the lowest since July 2020 (Figure 4). Taking a deeper look at the various components, new export orders and production fell sharply as fears of an economic downturn weigh on demand. At the same time, pressure on operating capacity eased owing to a reduction in backlogs. 

Figure 4: Weak manufacturing PMI data suggests that GDP growth is likely to slow

All in all, August’s PMI data points to further weakness in Korea’s manufacturing sector. Looking at the way things are going, Korea’s trade deficit is likely to stick around until next year, or at least until the global economy shows signs of a recovery. As such, we expect growth to continue slowing as the full effect of the global economic downturn kicks in.  

KOSPI’s high exposure to cyclicals plus chip industry downturn to weigh on performance 

Looking at things from a bottom-up perspective, another reason why we have turned less positive on Korean equities is because of the KOSPI’s high exposure to cyclical sectors, which tend to underperform the broader market when the economy isn’t doing well. The three largest sectors within the KOSPI Index – information technology, industrials and consumer discretionary (which collectively make up close to 60% of the entire index) – are all considered to be cyclical (Table 1). 

Table 1: The KOSPI index has a significant weighting to cyclical sectors

In terms of single securities, Samsung and SK Hynix – the first and second largest memory chip makers in the world – make up approximately 22% of the KOSPI Index. As a matter of fact, electronics (including semiconductors) form the largest category of Korea’s total exports at over 30%. With that in mind, it should not come as a surprise that the fortunes of Korea is closely tied to the health of the semiconductor industry. 

(Related Article: Semiconductors: Maintain 2.5 Stars “Neutral” as we await a better entry point)

Unfortunately, the chip industry has recently entered into the early stages of a new down-cycle that could last for several quarters. Following the pandemic-driven surge, global demand for semiconductors has fallen sharply this year, affecting many producers. Korea is no exception. According to data compiled by Statistics Korea, semiconductor shipments plunged by -20%, while inventory rose 67% year-over-year in August. Production has also started to moderate after peaking in late 2021 (Figure 5). 

Figure 5: Korea’s semiconductor shipments fell sharply while inventory surged

The recent trade figures are a clear indication that chip demand is no longer as robust as before. They also match the latest earnings guidance of Samsung and SK Hynix, both of which warned that demand for memory chips, especially those used in consumer-related applications (e.g. smartphones & PCs) are likely to see a sharp fall in the quarters ahead due to macroeconomic headwinds and the ongoing inventory correction. Both firms have also signalled plans to scale back on their capital expenditures. 

Even though both the Korean and Taiwanese economies have significant exposure to the chipmaking industry, Korea is likely to be more affected by the down-cycle given its heavy exposure to the memory market, where prices tend to be more volatile (Figure 6). On the other hand, Taiwan’s exposure is mainly to the foundry segment through TSMC (NYSE:TSMC), one company which we think will ride out the down cycle better than its peers.  

Figure 6: DRAM prices expected to fall further as the industry undergoes an inventory correction

(Related Article: TSMC: One company that will ride out the semiconductor down cycle better than its peers)

With that said, even though things don’t look as good as before in the near-term, investors should bear in mind that down-cycles will not last forever. The chip industry will eventually resume its growth trajectory once inventory levels have been sufficiently digested. As a matter of fact, we think that demand for semiconductors will likely be stronger than before due to (i) an increase in the number of applications, and (ii) the increase in silicon content in them. As such, we remain confident that Korean equities will do well in the long-run. 

Key investment risks

Global recession: Presently, most developed markets are struggling with rampant inflation, forcing central banks to tighten monetary policy aggressively or face the risk of runaway inflation. The European Central Bank delivered a 75 bps rate hike in September, while the Fed raised rates by 75 bps for the third time, reaffirming its hard-line approach to fighting inflation. A sudden rise in rates increases the odds of a hard landing, which will likely drive equity prices lower.  

However, as none of the major economies are officially in a recession yet, markets might not have priced in the full impact of a recession as of now, which leaves more room for share prices to fall if one should occur. 

Downgrade to 3.5 Stars “Attractive” as valuations not as attractive as before 

While Korean equities have done well last year, the export-led recovery is starting to fizzle out as the health of the global economy continues to deteriorate amidst high inflation and rapidly rising interest rates. On top of that, Korea’s significant exposure to semiconductors, particularly the memory market, is also likely to weigh on its outlook as the industry goes through a down-cycle. 

Although earnings downgrades have already started, more are likely to come. Under these conditions, we think that it could be difficult for Korean equities to produce the same kind of strong earnings growth as they did in the previous years. 

Applying our designated fair PE multiple of 12X on 2024E EPS, we arrived at a target price of 3,009 for the KOSPI Index. This implies an upside potential of approximately 35%. Although valuations are still relatively attractive compared to other markets, the upside potential is no longer as large as before. For these reasons, we have decided to downgrade Korea to a rating of 3.5 Stars “Attractive”.

Table 2: Earnings growth likely to be weaker in the near-term as the global economy deteriorates 

Figure 7: In the long-run, share prices are predominantly driven by earnings  

Investors who wish to seek exposure to Korea may consider our recommended ETF – the iShares MSCI South Korea ETF (NYSE:EWY). 

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.