Sell Korea: Weak Macro To Weigh On Equities – iShares MSCI South Korea Capped ETF (NYSEARCA:EWY)

The iShares MSCI South Korea Capped ETF (NYSE:EWY) is in a bear market down 4% YTD following a drop of 20% in 2018. The performance is related to macro headwinds including a slowdown in economic activity and exposure to Chinese trade uncertainties. I believe there is more downside ahead for EWY based on my view that the Korean Won has room to depreciate further which should pressure USD based returns in Korean equities. The setup here is the classic combination of slow growth, weaker fiscal and external-account conditions, coupled with a looming easing monetary policy cycle; the currency is set to head lower. This article highlights economic trends in Korea and my bearish thesis for the equity ETF.

iShares MSCI Korea Capped ETF weekly price chart. Source: Finviz.com

The following points highlight my short thesis discussed in more detail below.

Economic activity could underperform going forward

• Central bank GDP estimate for the year at 2.3% set to be revised lower.
• Poor sentiment around investment environment.
• Indicators such as declining credit growth suggest prolonged deleveraging.
• Unemployment to rise, adding to slowing consumer spending.

Expectation of further Korean Won Depreciation

• Weak GDP growth (cyclical slowdown).
• Strong US Dollar.
• Trending lower Chinese Yuan should pressure regional currencies.
• Low inflation allows central bank to cut monetary policy rate (lower rates).
• Government stimulus measures will worsen fiscal balance and public debt outlook.

ETF individual stock level holding analysis suggests some company specific weakness.

• Samsung Electronics (OTC:SSNLF) at concentrated 22% of the ETF is a near-term negative as the company faces global slowdown of smartphone sales and is reporting weak growth.
• High exposure to Automobile Industry (Kia/Hyundia) also a negative with slowing car sales and shipments globally.

Macro Overview

Korea’s economy has been decelerating in recent years, posting GDP growth of 2.7% in 2018, down from 3.1% in 2017. Q1 GDP was reported much lower than expected, with the figure showing the economy actually contracted on the quarter (-0.3%) compared to Q4 2018. Published economists’ forecasts were looking for positive growth of 0.3%. The annual rate of just 1.8% growth was the weakest since 2009. For the year, the central bank is still forecasting annual growth at 2.3%, but this figure is likely to be downgraded as it would require an acceleration averaging +1.0% q/q per quarter for the rest of the year which appears unlikely.

South Korea GDP growth. Source: tradingeconomics.com /author annotation

Economic activity

More concerning are the underlying figures that show a broad based cyclical slowdown across all areas of the economy. Between manufacturing, construction, investments, retail sales, exports, home sales, and unemployment, nearly every indicator has slowed or remains in contraction versus last year. The data i’m looking at comes from the Central Bank of Korea and the Ministry of Finance and Strategy. The Ministry made the following comments describing the Q1 situation.

“The economy over the first quarter of this year had to deal with a slowdown in major indicators as mining and manufacturing, facility investment and exports all declined amid a faster-than-expected global economic slowdown and weak semiconductor markets.”

The environment is not just limited to the industrial sector, the table below for services based sectors presents a depressing picture for the month of February. Take a look at the monthly economic bulletin published in English for some rather full charts and figures.

Korea Services Sector Growth. Source: Ministry of Finance and Strategy

External Accounts and Fiscal Balance

External accounts, including falling exports (down 8.2% y/y in March), has led to a narrowing current account surplus. I’m also looking at emerging weakness in fiscal accounts which have historically been a strong point for the Korean economy. The government announced a number of stimulus spending measures to support growth which should narrow the budget surplus while continued weakness in economic activity should lead to slower tax receipts, implying lower revenues. Public debt to GDP around 36% is relatively low by international standards, but I’d expect the figure to move higher going forward.

Korea public debt to GDP. Source: CEICdata.com

Monetary Policy

Consumer price inflation has been trending lower consistent with the apparent output gap now at an annual rate of 0.6%. Low inflation in the current environment provides the central bank with flexibility to lower rates to support economic activity. The central bank’s last policy action was in November 2018 when it increased the policy rate 25 bps to 1.75%. In the last meeting, the rate was held steady, although the statement released suggested they recognize the weaker than expected economic indicators.

Korea CPI and Monetary Policy rate. Source: Bank of Korea

FX

The current environment and evolution of the macro outlook suggest a weaker currency. Indeed, the Korean Won has depreciated about 10% over the past year. This performance explains part of the 25% drop of EWY in USD terms over the same period. 1 USD equal 1,190 KRW, a higher level here implies depreciation.

Data by YCharts

Foreign exchange is notoriously difficult to forecast, but in this case, I believe the ‘trend is your friend’. The KRW1,200 per USD level is fast approaching and my bet here is that it falls through over the next few months with KRW1,300 in sight from a technical standpoint. This implies another 10% downside in the EWY equity ETF for USD based investors. One factor that should continue to pressure the Korean Won is the trend of a weaker Chinese Yuan and implication for regional currencies.

EWY Analysis

The iShares MSCI South Korea Capped ETF with AUM of $4.4 billion is the largest and most liquid country specific equity fund for Korea.

EWY key stats. Source: iShares

Among 122 equity holdings, the concentration in Samsung Electronics is significant at 22%. The company is a major global electronics manufacturer across memory, chips, displays, mobile and consumer electronics. A weak semiconductor and smartphone sales market this year has been one of the reasons explaining the weak Korean economy. Shares of Samsung’s stock trading on the Korean market are down over 20% from their 52-week high as its profit has collapsed this year.

EWY sector exposure and top holdings. Source: yCharts.com

Korean car manufactures Hyundai Motor (OTCPK:HYMLF) (OTCPK:HYMTF) and Kia (OTCPK:KIMTF) along with the important automobiles industry are feeling the effects of weak car sales globally. Overall, global trade and export markets are important for Korean equities, but there is still significant exposure in EWY to local themes through financial services that represent 14% of holdings. A weak economy will continue to weigh on equities sensitive to domestic growth. Separately, a slowing Chinese economy represents a weakness for its smaller neighbor and major trading partner Korea.

Conclusion

The weakness in Korea is no secret evident by EWY down nearly 30% from its all-time high. Considering economic growth continues to slow down and signs point to further depreciation of the Korean Won, my belief is that there is more downside ahead for EWY. Investors in foreign stocks face the added risk of foreign exchange fluctuations, but a bearish position here will use that current weakness to its advantage. Investors need only to look at examples like the Canadian and Australian Dollar for examples of “developed market” currencies that have experienced significant depreciation (both down about 30% in the last 5 years). The Korean Won could be no different.

My price target for EWY is $45, retesting its 2016 low and representing 20% downside. Korean equities at this time are a speculative play for both bulls and bears. The potential for better than expected economic acceleration or rebounding currency would be a positive for EWY. Considering global trends, I believe risks are tilted to the downside.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.