Korea — when it rains, it pours


A major concern about South Korea’s economy is the high household debt which currently stands at 96.9% of its GDP at the end of third quarter (3Q) 2018.

As high household debt could hinder future consumption growth, the Bank of Korea (BoK) and the government have stepped up efforts to control the pace of growth in household debt.

According to the second half (2H) of 2018 BoK’s Financial Stability Report, household debt growth has indeed slowed down.

However, the household debt-to-disposable income ratio grew even higher to 162.1% as disposable income growth slowed more than household debt growth.

Household loan-to-income ratio of vulnerable borrowers are still extremely high at 259.6%.

Despite the problems of a minimum wage hike, the unemployment rate has improved drastically after hitting a nine-year low in January.

Although it is not certain that the unemployment rate will hold in the future due to the minimum wage hikes, consumer sentiment, as measured by the BoK’s Consumer Sentiment Index, is improving.

With higher government expenditure to support a higher minimum wage, we could see an improvement in delinquency rates of household loans and the issue of high household debt in South Korea.

Higher frequency Business Survey Index (BSI) offers a clue of bank earnings in the short term as the strong uptick in March could set a precedent for things to come. The banks went through a tough 2018 with the South Korean economy being affected by the US-China trade spat and a slowdown in the semiconductor, automobile and shipping industries.

Stock prices of banks tend to trend along with the non-manufacturing BSI. However, sudden changes in the BSI tend not to be reflected in stock prices.

Thus, it is important to ascertain whether South Korean businesses are getting more optimistic of the future.

A challenge that banks face is the probable lack of movement in domestic interest rates.

With high household debt and low inflation, the BoK will find it difficult to raise rates in the future, having already done so in 4Q18.

Since banks’ net interest margins are affected by the base interest rate, margins are probably not going to increase much in the future.

However, loan volumes should grow, which should see earnings rise.

The decreasing pace of deleveraging and economic growth bodes well for South Korean exporters and industrial sectors as well as IT stocks like Samsung Electronics Co Ltd and SK Hynix Inc.

Sentiment is improving with businesses and consumers reporting higher confidence in the future.

However, the question we should ask is: Is the uptick here to stay?

On the China front, soft data and policies suggest a strong rebound in future hard data alongside stock prices (excluding the effects of trade tensions escalating), which could boost consumer confidence and spending although there are some concerns of speculations involved.

Prices of companies in the MSCI Korea Index have started to recover after last year’s sell-off although the recovery is relatively muted compared to other markets.

Analysts estimate earnings are heavily negative at -25.5% and 20.1% growth for FY19 and FY20 which have caused forward price-to-earnings (PE) ratio to shoot up dramatically.

This means analysts are still projecting a negative outlook for South Korea with earnings for the next three financial years being aggressively downgraded.

Prices have started increasing which makes the index look expensive due to its poor earnings.

However the forward PE ratio should come down as analysts start to upgrade earnings projections which give further room for price appreciation.

The lingering memory of Korean stock prices being stagnant from 2011 to 2016 could deter investors from Korean equities, which could affect upwards momentum in the future.

If semiconductors firms fail to still provide earnings surprises after the negative forward guidance or postponing the proclaimed 2H recovery, we could see Korean indices erasing their gains for the year.

We set a rather conservative price target of the MSCI Korea Index at 820, targeting a forward PE ratio of 11x at 2021.

This accounts for earnings expansion and a recovery in investor sentiment as valuations improve.

Our conservative estimate is a 20% potential upside, while the optimistic scenario could see a total upside of 40%.

Considering the above, the risk reward for Korean equities is rather attractive.