A lot of investors recoil from uncertainty. Uncertainty, like a volatile regional neighbour, a huge political corruption scandal and a deposed president, doesn’t sit well with a lot of investors.
This sort of thing is exactly why many investors keep their portfolios at home.
But if you’re shying away from uncertainty, you could be missing out on big gains.
Just look at South Korea…
South Korea (which I recently visited) is a market full of uncertainty. Its northern neighbour is led by an impulsive despot (even if a war of anything other than words is unlikely). The country was recently immersed in a corruption scandal for months. It’s on the wrong side of U.S. President Donald Trump (though a recent visit of the country’s president to the American White House wasn’t all bad news). And China is also not pleased with it.
Yet, South Korea’s Kospi Index is hitting six-year highs. It’s up 18 percent so far this year in dollar terms, about the same as the MSCI Asia ex Japan Index. Meanwhile, the MSCI World Index is up around 12 percent this year. But as shown in the chart below, South Korea has underperformed over the past five years.
And the funny thing is that if you looked at the news coming out of South Korea, you’d expect the market to be down.
Corruption and impeachment
Politics is one problem. In October 2016, it was revealed that then-President Park Geun-hye let her personal friend, Choi Soon-Sil, interfere with and influence several of her political decisions. Park’s office directed millions of dollars in donations to Choi’s foundations. For example, consumer electronics company Samsung donated at least US$60 million to Choi’s foundations – based on a request from Park’s office. Some of the donated money was even used to fund the equestrian training of Choi’s daughter.
So on December 9, 2016, the South Korean parliament voted unanimously to impeach Park. After a landslide election in May 2017, South Korea elected liberal Moon Jae-in as its new president.
Moon won support by saying he would cut government ties with influential corporate conglomerates, called chaebols. (South Korea’s leaders are notorious for their favouritism to big businesses). He also promised to reduce unemployment and income inequality.
Moon has also talked about opening a dialogue with North Korea – to win its friendship with aid and trade. But this could put pressure on South Korea’s relationship with the U.S. – which is threatening North Korea with military action and enhanced economic sanctions.
The North Korea threat
North Korea and the rest of the world have disliked each other for the past few generations. And recently, tensions have been escalating as North Korea continues its missile tests. The country has fired 16 missiles in 10 tests so far in 2017.
While it’s believed that North Korea is trying to perfect its technology to create a missile capable of reaching the U.S., South Korea and Japan remain vulnerable targets for the arsenal.
But as I noted earlier, Moon is hoping to improve South Korea’s relationship with the North.
The Trump factor
Relations between Asian countries (or pretty much any country, for that matter) and the U.S. have been uncertain since Donald Trump was elected president. As we’ve talked about before, Trump has been shying away from the global stage. And his policies could significantly reduce foreign trade.
In South Korea, that means Trump could renegotiate or terminate the U.S.-South Korea KORUS Free Trade Agreement, which came into effect in March 2012.
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KORUS eliminated 80 percent of tariffs on industrial and consumer products. Ninety-five percent of tariffs were due to be eliminated by 2017, and the remainder by 2022.
But Trump has repeatedly called the agreement “unfair” for the U.S. And he has vowed to renegotiate or terminate the deal.
The implications of this could be massive for South Korea. South Korea’s exports make up a massive 45 percent of its GDP. The U.S. is South Korea’s biggest export destination. So a renegotiation or termination of the deal could significantly affect South Korea’s future economic growth.
Tensions with China
South Korea’s relations with China have also come under strain recently. Earlier this year, South Korea agreed to deploy a U.S. missile defense system to protect the South against North Korea.
China’s government expressed its displeasure with this move by telling Chinese travel agencies to cut the number of tourists visiting South Korea by 20 percent annually. This is a big deal – since Chinese tourists make up half of total inbound tourist traffic in South Korea.
The Chinese also started boycotting South Korean companies like retail operator Lotte Shopping Co. and Amorepacific Group, which makes beauty and cosmetics products.
In June, South Korea put further deployments of the system on hold. This might appease China, but it could strain its relationship with the U.S. even more.
So all in all, South Korea is facing an uncertain political and economic future right now.
But that hasn’t stopped investors from pouring in…
South Korea’s stock market keeps heading higher
According to Bloomberg, foreign investors injected more than US$15 billion into South Korea’s stock market over the last 12 months. Meanwhile, by comparison, foreign investors put less than US$8 billion into India’s market.
Despite the recent run-up in South Korean shares, the market is still cheap. One useful valuation metric is the cyclically adjusted price-to-earnings (P/E) ratio (or CAPE). This gives a more complete valuation than the normal P/E ratio, as it adjusts average earnings for inflation over a much longer period. This smooths out one-off events that can distort the P/E ratio.
South Korean shares are cheap on a CAPE basis, as the graph below shows.
In fact, South Korea is one of the cheapest markets in the world on a CAPE basis. With a CAPE ratio of 13.7, it’s cheaper than China (14.4), Hong Kong (16) and Malaysia (16.2). And South Korea is much cheaper than the three most expensive markets on a CAPE basis – Denmark (34.1), Ireland (33.7) and the U.S. (27.5).
However: South Korea’s stock market is often cheap. So that it’s cheap now doesn’t necessarily mean that much.
South Korea’s stock market is still positioned to do well
So why is South Korea moving higher despite the uncertainty?
As we’ve seen in the U.S., the hope of new policies can move markets – a lot.
Investors in South Korea are buying into the hope that things will change with its new leader. They’re banking on Moon being able to improve foreign relations, reduce income inequality and unemployment and crack down on conglomerate favouritism.
And South Korea’s economic growth has also picked back up this year – encouraging more investment into the market.
In the third quarter of 2016, South Korea’s GDP growth slowed from 3.3 percent to 2.7 percent. This, coupled with the political scandal, caused many analysts to revise their growth predictions down to 2.4 percent for 2017.
But in the first three quarters of 2017, annual GDP growth was 2.9 percent year-on-year – thanks to rises in manufacturing and construction.
Also, what bothers journalists doesn’t necessarily bother investors. And don’t forget… it’s all about your time frame. How markets view a policy or politician changes over time. Today’s contrarian view is tomorrow’s consensus view. Measures or words that bolster markets now may be a slow-burn fuse that blows them up months later.
And finally, although Korea’s stock market has done well in recent months, it has a lot of room to play catch-up on a longer-term basis. Over the past five years, the South Korean stock market is up only 39 percent – compared to 49 percent for the MSCI Asia ex Japan Index, and 70 percent for the MSCI World Index.
If you also think that South Korean shares are headed higher, one of the easiest ways to profit is to invest in exchange traded funds (ETFs) such as the iShares MSCI South Korea Capped ETF (New York Stock Exchange; ticker: EWY); the iShares MSCI Korea UCITS ETF USD (London Stock Exchange; ticker: IKOR); the Value ETF Korea (Hong Kong Stock Exchange; ticker: 3041) or the db x-trackers MSCI Korea Index UCITS ETF (Singapore Stock Exchange; ticker: IH2).
Publisher, Stansberry Churchouse Research