South Korea: A Standout Performer In Emerging Markets by Eswarie Subrahmanyam S. Balan, Research Analyst, The WisdomTree Capital
Thus far in 2015, equity returns in emerging markets (EM) have lagged those of Europe, Japan, the U.S. and the broader developed world.1 As EM equities battle their largest outflows, rivaling that of 2008,2 the trinity of excessive pessimism, attractive fundamentals and supportive macroeconomics may present unique opportunities in the region.
Not all emerging markets are built alike; below we highlight a few areas worth exploring.
EM Landscape: Korea Resilient Amid Sell-Off
Greenhaven Road Capital commentary for the third quarter ended September 30, 2022. Q3 2022 hedge fund letters, conferences and more Dear Fellow Investors, The Fund is enduring its worst drawdown since inception. We were down again in the third quarter, bringing year -to-date returns to approximately -59%. Returns vary by . . . SORRY! This Read More
For definitions of indexes in the chart, visit our glossary.
Theme 1: Resilient Korean-Hedged Index: In spite of the broad EM sell-off in 2015, Korea is in a class of its own, having returned 2.6% on a currency-hedged basis, while the broad MSCI EM Index contracted 8.3%.
- As recently as mid-September, Standard & Poor’s (S&P) upgraded Korea’s credit rating to AA-, the highest level in nearly 18 years. It said Korea is likely to maintain economic growth higher than most developed economies over the next three to five years. S&P is further encouraged by the decline in external debt owed by Korean banks and reduced short-term borrowing in total external debt.
- Many fear that EM will falter when the Federal Reserve (Fed) raises interest rates and investors are forced to reassess EM’s yield advantage. Interestingly, Korea is on better footing, considering its total debt owed to foreigners is relatively low at 38% of gross domestic product (GDP).3
- Lower commodity prices have also benefited importers such as Korea by helping reduce their import bills. It comes as no surprise that Korea has seen vast improvements in its current account dynamics. It most recently recorded a surplus of 7.3%, the highest since 1999.4
Theme 2: Blame It on EM Currencies: EM has been caught in a storm of disappointing performance largely attributable to currencies. In a prior blog post, we argued that EM currencies could offer good value and support the valuation case for already depressed equity price multiples in the region. Meanwhile, given the steep cost to hedge many EM currencies, investors are forced to contend with shorter-term EM currency volatility.
- Currencies account for between 75% and 90% of the negative returns experienced by the broad Indexes listed above.5
- EM currencies are a tale of two economies—commodity importers and exporters. The commodity-exporter currencies, such as the Brazilian real, Turkish lira, Malaysian ringgit and South African rand, are the main underperformers this year, having depreciated anywhere between 13% and 30%.6 While not immune to the sell-off, commodity-importing currencies such as the Taiwanese dollar and Indian rupee have held up better, having only depreciated between 2% and 3%7.
- The WisdomTree Korea Hedged Equity Index seeks to include profitable Korean companies while neutralizing currency exposure at an annualized cost of 1.2%. In comparison, currency hedging in the broader EM complex is far more costly, with currencies in MSCI EM costing almost 4.5% annually to hedge.8
- The Korean currency was down 4.7% this year, but the hedged nature of the Korea Hedged Equity Index can neutralize this decline.
Theme 3: Quantifying Equity Valuations: EM equities are currently trading at fairly low valuation multiples, with some countries testing the single-digit price-to-earnings (P/E) ratio territory—like China and Russia. Contrasting a country’s earnings yield to its equivalent 10-year local government bond yield further helps evaluate equities compared to the alternative fixed income vehicle.
- Equities in China, Taiwan and Korea have the highest earnings yield compared to their local 10-year government bond yields. Incidentally, these are also commodity-importing nations. The yield differential between equities and bonds ranges from 6.9% to 7.1%, helping make a stronger case for equities in these regions.
- Russia comes in at a close fourth, with an earnings yield of 16.95%, the highest in the EM block, and a nominal 10-year bond yield of 11%. This implies an equity yield advantage of 5.9%9.
While the EM region remains a tricky landscape to navigate, we believe it is important to be able to concentrate on areas in EM where both cyclical and structural factors align to support equities and currencies. Korea makes for an interesting market that stands out for its performance in 2015, relative low cost to hedge against currency weakness and fairly wide spreads for earnings yields compared to bond yields.
1Source: Bloomberg. Refers to the 12/31/14 to 10/9/15 performance of the MSCI Europe, MSCI Japan, S&P 500 and MSCI EAFE Indexes, respectively.
2Source: Deutsche Bank, EPFR data as of 10/9/15.
3Source: Bloomberg, total external debt to GDP as of 6/30/15.
4Source: Bank of Korea, Bloomberg, as of 6/30/15.
5Source: WisdomTree, Bloomberg, as of 8/31/15. Refers to WisdomTree Emerging Markets High Dividend Index, WisdomTree Emerging Markets SmallCap Dividend Index, WisdomTree Emerging Markets Quality Dividend Growth Index, WisdomTree Emerging Markets Consumer Growth Index and WisdomTree EM ex-SOE Index.
6Source: Bloomberg, as of 10/9/15.
7Source: Bloomberg as of 10/9/2015.
8Source: Bloomberg, as of 9/30/15.
9Source: Bloomberg, as of 10/9/2015.
Important Risks Related to this Article
Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments.
Investments focused in South Korea increase the impact of events and developments associated with the region, which can adversely affect performance.
Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations.
Hedging can help returns when a foreign currency depreciates against the U.S. dollar, but can hurt when the foreign currency appreciates against the U.S. dollar.