By Geoff Lewis
Vice president and head of investment services of JPMorgan Asset Management

Since Asian stock markets first began their recovery rally in October 2003, Korea has taken the role of both hare and tortoise to the region in turn. As a result, Korea has appeared as one of the more volatile, higher beta choices to international investors keen to increase their exposure to Asia during the secular rally in global equities.

As the upswing in global equities gathered momentum in 2005, Korea was the strongest performing market in Asia Pacific by a wide margin. The KOSPI local market index rose 58.7 percent in U.S. dollars, more than two and a half times the 21.3 percent increase in the MSCI Far East ex-Japan index.

A burst of exceptional performance by a stock market often appears to demand some subsequent ``payback.'' And in the following year, 2006, Korea soon switched from top of the Asian performance league to being one of the region's worst laggards.

The KOSPI disappointed local and overseas equity investors with a rise of 13 percent, less than half the regional return of 31.7 percent (MSCI Far East ex-Japan index).

In Asia, only the military coup-afflicted Thai stock market fared worse than Korea last year. Reversals after very strong short-term performance are not uncommon, especially if investors conclude that a market has ``got ahead of itself,'' as Korea appeared to do in the fourth quarter of 2006.

There was a strong temptation to book profits that in turn can lead to expectations becoming self-fulfilling.

However, in Korea's case, the big switch in fortune in 2005 and 2006 from Asian star to under performer was due to far more than just rotational selling.

The explanation in our view is tied closely to Korea's remarkably high leverage to the global business cycle. Korea's major industrial exports are predominantly cyclical items such as semiconductors and other electronic components, basic or intermediate products like chemicals, plastics and metals, and transport machinery _ ships and autos.

Korea in the past has depended heavily on manufactured exports as the key driver for economic growth. Though by Asian standards it could be deemed a regional economic ``heavyweight,'' prior to the industrial emergence of China, which should have been encouraging a bigger role for domestic demand in the growth process.

In view of the exceptionally robust global economy, once the post-2003 rally took hold in Asia, international equity investors began to look very favorably on Korea as a high beta play on global growth.

As the economic upswing matured and progressed with surprisingly few signs of inflation pressures, the outlook for many of Korea's large cap exporters would have appeared to have been amongst the brightest in Asia.

Hence the exceptionally strong KOSPI rally that took Asia by storm in 2005. But as we now know with hindsight, Korean leadership was brief and expectations of further gains early in 2006 were soon dashed.

Markets soon became fixated on the U.S. residential construction collapse, mortgage equity withdrawal and the idea that the U.S. economy was about to enter a prolonged weak patch, possibly even recession.

When the US GDP data for the first quarter of 2006 revealed a surprising degree of weakness, equity investors switched to regarding Korea's high cyclical leverage as a potentially big negative.

Korea and Taiwan, Northeast Asia's two tech-oriented exporters, fell out of favor for almost the entire year.

They were seen as being the most vulnerable markets in Asia to a fall in U.S. import demand. Instead, investors in 2006 focused more on the buoyant ASEAN markets, as suppliers of food and other commodities to a booming China.

Contrary to the concerns of investors, Korea's vulnerability to a slowing U.S. economy in 2006 proved to be negligible.

Exports to the U.S. in value terms indeed flat-lined last year, but overall export performance went from strength to strength as other markets replaced the U.S. as a source of growth.

Korea's dependence on the global cycle remains high, as until today domestic demand has failed to come up to the plate.

But a still high global beta for Korea conceals some large and important changes to betas at the regional level.

Not only have Korean exports to the U.S. been eclipsed by exports to China at $6.6 billion in 2006 and Europe is also a significantly bigger export market for Korea today than America, worth over $5 billion.

Another booming market for Korean exports is the Middle East, worth $1.8 billion. By contrast, Korea sells relatively little to slow-growing Japan, just $233 million in 2006.

So Korea has been unaffected by the Japan's recent weak patch, being far more geared into the world's growth ``hotspots'' like China, Russia and the Middle East.

Korea's consistently strong external performance in recent quarters was recognized by investors with a dramatic market rally in the second quarter that continued in July, a month which saw the KOSPI up a remarkable 11.4 percent.

Sentiment towards Korea is once again at high, almost euphoric levels. Investors have poured $1.1 billion into Korean funds year to date, the 2nd highest in Asia after Singapore, and treble the amount invested in the same months last year.

Plus after six consecutive positive monthly returns _ a long run by historic standards _ it is hard not to see Korea as close to fully valued from a short term perspective.

Overbought on technical grounds, U.S. subprime woes could well be the excuse for a more prolonged technical correction to KOSPI in volatile summer trading, though as yet Korea has fared no worse than the regional average.

Switch to a longer horizon, however, and the regional managers are turning very positive towards Korea.

Over 12 to 18 months, they think Korea could turn out to be one of Asia Pacific's most interesting and rewarding markets.

Macro news continues to be little short of stellar. Buoyed by robust exports, GDP in the second quarter this year grew by 1.7 percent from the previous quarter, beating forecasts and the fastest pace in 18 months.

The won may be close to a 10-year high versus the dollar, yet overseas shipments in the second quarter increased at almost double the first quarter's rate.

Less positive, private consumption growth slowed to 0.8 percent from the previous quarter, down from 1.5 percent in the first quarter.

This was seen as a negative, as evidence that high household debt still constrains and crimps the Korean consumer.

But in our view, consumer recovery has merely been delayed, and Korea's good job market plus spill-over effects from strong export and capital spending mean there is every chance of a more robust consumption trend taking hold in the next few quarters.

With the economy's macro outlook so robust, corporate Korea should exhibit resilient earnings growth, thanks primarily to strong exports and steady domestic demand.

Exports _ still the main driver of growth _ fortunately appear less sensitive to the foreign exchange rate than many investors fear.

Partly, this reflects the won's more stable effective exchange rate index. Further, market rallies may well require prior confirmation of sustainable domestic consumption as well as more stable commodity and energy prices.

But we see a very good chance of this, while Korea's technology sector should also see an earnings rebound.

As TFT-LCD makers limit further capacity increases, industry returns should improve as pricing pressures ease, while on the DRAM side increasing volume sales should mitigate some of the recent price declines.