From Squid Game to semiconductors

Since the late 1990s, the Korean Wave, or “Hallyu”, has been gaining momentum. The country has enjoyed phenomenal success in exporting its popular culture around the world, benefitting from growth in the internet, smartphones, and online video streaming along the way. Many will be familiar with K-pop and K-dramas, in particular last year’s Netflix hit, Squid Game.

Of course, Korea’s export success is not limited to the cultural sphere. Broad export revenues have surged in the past 20 years, having begun to pick up in the 1980s as export-oriented policies paid off.

Though the idea of emerging market (EM) convergence is much debated, South Korea is an economy which has exhibited a strong convergence trend. This has been underpinned by investment in physical and human capital. GDP per capita relative to the US was just 3% in the early 1960s. It climbed to over 40% in 1996 and is around 50% today.

South Korea is now the tenth largest economy in the world, and is increasingly significant in a wider emerging Asia context. China is its largest trading partner, followed by the US, but other regional markets such as Vietnam are growing in importance. Ties with India and other Association of Southeast Asian Nations (ASEAN) have also been prioritised.

From an investment perspective, the equity market encompasses a range of sectors and is home to various long-term thematic growth opportunities. Some of these rank not only among the best in EM, but also globally. In the near term, uncertainty has increased as slower global growth weighs on the outlook for exporters, and as geopolitical risks remain. But we think there is good reason to look through the oscillations in the global economic cycle.

Why GDP growth has been slowing

Economic growth was stronger than expected at 2.9% year-on-year (y/y) in Q2, ahead of expectations and only marginally lower than the 3.0% recorded in Q1. After peaking at 6% in the Covid recovery in Q2 of 2021, growth has normalised, and there are downside risks in the outlook.

Exports as a percentage of GDP have fallen to around 37% in recent years, from a peak of almost 55% in 2012, but remain significant. Close to a third of exports are electronics, which have been hit by a post-Covid re-orientation in global demand from manufactured goods to services. Slower growth in the US and China, South Korea’s largest exports markets, is also likely to pressure demand.

This impact is already evident in high frequency data, with manufacturing PMI trending down. In July it moved slightly below 50, the threshold of contraction/expansion, for the first time since 2020. We expect further deceleration in the coming months. Meanwhile, business and in particular, consumer confidence, have been falling.

Inflation is accelerating

Headline inflation has accelerated in recent months, as the impact of higher food and energy prices, following Russia’s invasion of Ukraine, feeds through. The consumer price index was up 6.3% y/y in July, its fastest rate since November 1998.

This is well ahead of the central bank’s 2% target rate, and it began lifting the policy rate from its Covid low of 0.5% in August of last year. After increasing the pace of tightening to 50bps in July, the largest since the bank adopted interest rates as its primary policy tool in 1999, the main interest rate now sits at 2.25%. Further rate rises are expected in the coming months, but concerns about high household debt levels may temper the pace of policy tightening somewhat.

Trade data has turned

The trade account has moved into deficit in recent months as imports exceed exports, largely due to commodity price rises. Exports have been relatively resilient so far, but there is downside risk should major global economies move into recession. The current account remains in surplus at $5.6 billion but has been coming down, which has not helped the currency in the face of a strong US dollar. As at the 15 August the won is down just shy of -9% year-to-date.

The won now screens as cheap on both a five-year and longer-term basis, as shown below.

What are the long term growth opportunities?

Semiconductors

South Korea’s largest export is integrated circuits, also referred to as semiconductors or microchips,  and it is the third largest exporter globally. Microchips are primarily used in electronic devices such as computer processors and are largely analogue or digital. The latter divide into two categories, 1) Memory, used for storing data, and 2) Logic, used for processing data.

The industry has historically been prone to boom-and-bust cycles, owing to its reliance on consumer demand for electronics. Semiconductor cycles are now being compressed, as broader demand sources create a strong secular growth trend for the industry. Semiconductor sales as a share of GDP are rising and may climb above historical levels.

Smartphone growth has slowed, but the roll-out of the fifth generation, or 5G, wireless standard, which will offer higher data speeds, reliability and capacity, is supportive in the near term. PC demand has also been revitalised to some extent through the pandemic. Other demand sources come from the growth of data centres and digital service offerings, the so-called internet of things (IoT), and the auto industry. Semiconductor content in cars generally, in particular electric vehicles (EVs), continues to rise. And as EV battery packs increase in size, more complicated semiconductors will be needed.

Electric vehicles and battery cells

South Korea’s second largest export is cars, and it is the fourth largest exporter globally. The autos sector is highly cyclical, but the country is also a major exporter of electric cars, which is another long-term growth area.

The largest car manufacturers have seen sales of EVs soar in recent years and EV penetration still has a long way to run. Traditional internal combustion engine (ICE) powered car sales will fall as EVs rise. This is challenging the status quo in auto market leadership and there is an opportunity for South Korean players to take market share. However, competition is a risk and one can argue that the opportunity for product differentiation in EVs is more limited than in ICE powered cars.

Another element of the EV trend is battery cell technology. Rising EV penetration represents a major growth opportunity for battery makers; research from McKinsey points to annual growth of over 20% until 2030. However, the battery industry is much more concentrated than the auto industry and carries higher barriers to entry which should lead to better returns through time. South Korean battery companies are among the global industry leaders in technology and scale. The strong growth outlook will require significant investment in future capacity and the growth of battery ecosystems has potential for positive spillovers in terms of supply chains This includes investment in infrastructure clusters and associated plant and machinery, job creation and upskilling of labour, all of which have potential to increase barriers to entry.

South Korea is exposed to geopolitical risks

The conflict with North Korea, which began in 1945, is technically ongoing. Despite some improvement in relations in 2018, which culminated in the Panmunjon Declaration, relations remain strained. Together with its military alliance with the US, which played an important role in the modern state’s founding, this has previously contributed to tensions with China.

Perhaps more importantly, South Korea is also a long-term strategic competitor to China in a number of industries, including technology. The trend to diversify supply chains to reduce reliance on China may dilute this risk to some extent, but Chinese companies are expected to continue to invest to move up the value chain, bringing greater competitive intensity.

In domestic politics, President Yoon was elected in March this year. The conservative leader is proposing more market-friendly measures, but has seen his popularity fall and congress remains controlled by the opposition. Historically, conservative presidents have taken a slightly firmer approach in relations with China, though his initial focus has been on improving relations with Japan.

Market

The MSCI Korea Index has been increasingly dominated by the IT sector over the past 15 years; IT has an index weight of 45%. Semiconductor industry growth is a big part of this.

IT, together with other cyclical sectors (financials, industrials, materials, communications services and energy) have an index weight of around 90%. This makes the MSCI South Korea one of the most cyclical markets in the MSCI Emerging Markets Index.

Given higher fluctuation and less predictability over earnings, investors typically value cyclical stocks lower. One consequence of this is that the South Korean market tends to appear relatively cheap when compared with other EM, as the chart below illustrates. As at 16 August, the MSCI Emerging Markets is only slightly below the median forward price-earnings ratio since 2000. South Korea on the other hand is cheaper relative to its historic median.

Another perspective is to look at valuations of the South Korean market relative to its own history. Along with many other EM, Korean stocks are currently cheaply valued compared with historical experience.

A final point to note is the sharp rise in retail investor participation over the past few years. Koreans have in recent decades favoured investing in non-financial assets, primarily real estate. A combination of high property prices, interesting stock market opportunities, and more focus time through the pandemic, has led the number of stock accounts to almost double since 2019. Rising interest rates are now dampening retail investor demand, but it remains a trend to monitor.

There is much to like in South Korean equity market

Global markets have enjoyed something of a bounce through the Northern hemisphere summer, as markets weigh up the outlook for Fed policy. South Korea has participated in the rally, outperforming the MSCI Emerging Markets Index, for which China has been a drag.

Despite recent market performance, uncertainty remains elevated and the risks to global growth and trade continue to permeate. In this context, downside risk for earnings remains, which would have implications for Korean markets. On the other hand, valuations for the market as a whole are now much more interesting.

Looking beyond these near term clouds and uncertainties, there are a number of long term growth themes in South Korea. Semiconductors and batteries in particular stand out, and South Korea is home to top five global players in both industries. While the market may yet be buffeted by crosswinds from the global economic cycle, we think these businesses are well-set for the longer term, and market weakness may provide long-term opportunities.

In summary, we may see near-term volatility and headwinds, but the market offers structural and cyclical opportunities at attractive valuations. And the Korean market will at some point will begin to anticipate the end of the downcycle, and move accordingly.

Originally published by Tom Wilson Head of Emerging Market Equities and Andrew Rymer, CFA Senior Strategist, Strategic Research Unit, Schroders