Another year of living dangerously
Financial Services Commission Chairman Shin Je-yoon, fourth from left, and Korea Exchange (KRX) CEO Choi Kyoung-soo, third from left, celebrate the opening of the bourse for the year 2014 with other guests at the KRX building in central Seoul, on Jan. 2.
By David Chon
David Chon, co-CEO of KDB Asset Management
As we start another new year, there is much anticipation of an economic recovery around the world. Financial markets are looking at the U.S. and Europe to lead the global economy out of the doldrums. In a way, a new year brings a new start and we get a blank sheet to fill with hopes for the upcoming 12 months. As we look back over the past five years since 2008, the global economy was supposed to have been recovering every year since then. Will this really happen this year? The real honest answer is that we don’t know. There are too many unknown variables and too many possible permutations of interactions of factors to declare that we are through the storm and can face calm waters with a friendly wind on our back. In fact, as we do a reality check on some of the key factors around the world, 2014 could be a very challenging one. It is likely to be another year of living dangerously.
Liquidity paradox in U.S.
One of the legacies of the Bernanke Fed is that they taught the rest of the world esoteric concepts such as QE, Operation Twist, tapering etc. We are now all experts on these topics. In 2013, the Fed introduced the concept of tapering. They waited until budget impasses were resolved and the GDP was at 4.1 percent to do a minor tapering. Many market participants are now saying that because there were no major market reactions to tapering, the markets must have already discounted the full impact of tapering. I disagree with this logic. This is a similar logic to concluding that a patient is cured of pain after reducing their pain killer dosage from a necessary 400 percent to 390 percent. The patient is still not well. Why does the U.S. still have near zero interest rate when the economy is growing at 4 percent? What is the Fed afraid of?
These are very important questions that the market is not asking. They are only looking at short-term market reactions (which is much more influenced by the abundant liquidity than fundamental factors) to back into the fundamental tea leaf reading. The simple reason why the Fed can’t exit from the QE quickly is that even after the $3 trillion dollar liquidity tsunami, the U.S. economy is still fragile. It still needs an artificially low interest rate to create new loans and service existing borrowing. This is the experiment that the U.S. will undertake in 2014: reduce liquidity injections while not disrupting the ever-so fragile economic recovery. If the Fed is not declaring that the U.S. economy is not yet back on a solid footing, why are experts in Korea saying that it is? Do the experts in Korea know something that the Fed does not? At this juncture in the U.S. liquidity cycle, a prudent approach is to wait and see how the unwinding of the liquidity ramp-up impacts the real economy and markets.
Bubble toil and trouble
From the golden cow sitting in the lobby of a sparkling Shanghai high rise to signify abundance to a roaring super car racing down a Gangnam street in Seoul, the global liquidity party has touched us all. We now have two main creators of the liquidity bubble, the U.S. and China, declaring that they are intending to start curbing the pace of liquidity creation. How worried should we be with the prospects of the beginning of the end of the global economy’s biggest liquidity binge? Simple answer is very! One minor example in modern times was back in the early 1990s.
To save Citi Bank and help the U.S. economy out of recession, the Fed ran the U.S. interest rate below the inflation rate for about two years. This helped the U.S. economy out of recession but also created a disaster for emerging economies. After a cheap dollar financing induced borrowing spree, emerging economies were left with excess borrowing and a rising interest rate predicament. Mexico blew up in the winter of 1994 and most EM countries (including Korea) went through a major financial crisis. This chain reaction culminated with the Russia crisis in 1998. That was just with the U.S. taking the liquidity punchbowl away after injecting a mere $30 billion of liquidity. Over the past 5 years, the U.S. alone injected $3 trillion of liquidity. The EU, Japan and China also increased its central banks’ balance sheet by $7 trillion during the same period. To say that marginal removal of this massive liquidity will have no impact would be irresponsible. To say this is the end of the global financial market would also be fatalistic. Yet, most market experts do say this won’t matter. Choose your experts carefully. Over-extended bubbles will be impacted first. This is how we can begin to analyze how the global setup in 2014 can impact the Korean financial market.
For Korea, China is more important than U.S.
One of the biggest beneficiaries of the U.S. QE party has been large emerging economies. India, Brazil and China all partied hard over the past five years. They built buildings and roads regardless of the return on these projects. They invested in capacity assuming that demand growth will continue at a super fast rate and they borrowed to invest and consume. A turn in this trend is likely to take place in 2014. Just like any credit bubble, when the speed at which the credit is created decelerates or underlying economic growth slows after a rapid credit expansion takes place, bad things usually happen.
Well this is the setup for the three countries. With the Chinese government declaring stability over growth for 2014, the likelihood of lower-than-expected economic growth is becoming a higher probability scenario. Without contemplating the possible credit cycle situation in China, the slower growth alone can impact Korea in two ways.
The Korea Inc. also invested heavily in China, believing the continuation of high growth. It will impact return on these investments made by the Korean companies.
Also, if the marginal final demand of commoditized goods erodes due to China’s slowdown, the Korean companies in highly cyclical sectors will also be impacted from the softer price of goods they manufacture. It looks like a decision is made to reduce the credit binge-driven growth in China. We need to monitor how this impacts their growth and existing credit condition of their exponentially risen borrowing pool. This is important for Korea.
What about Korea?
Korea is one of the few countries in the world that still has both monetary and fiscal stimulus bullets at its disposal. Many other countries have maxed out on these tools with interest rates already near zero and fiscal deficit and debt levels hitting ceilings. From this perspective, Korea has room to maneuver. The key for Korea is how to use them. If Korea “wastes” these valuable policy bullets just reacting to external factors without its own medium-to long-term game plan, then after a while, Korea will be at a similar place like other countries without policy options. Some current examples are India and Brazil. They are forced to raise their interest rate in spite of the slowing growth. The liquidity-induced easy money policy is catching up to them. Both the U.S. and the EU are facing fiscal constraints as well. Unlike these countries, Korea actually has policy tools left. It still remains to be seen whether Korea uses these policy bullets to come up with a short-term fix or uses them in a strategic manner to realign Korea to be competitive in a post-QE global economic landscape. Even a strong and stable ship does rock in very turbulent waters. Korea’s economy cannot escape the risks in the global economy. It would be better for Korea if it uses its resources to get its ship to the destination that fits her strategic goals rather than wasting them to stabilize the ship in turbulent waters.
What to invest in Korea?
More important than “what” to invest in Korea is “how” to invest in Korea. In 2014, there is a possibility of high volatility in both stock market and bonds in Korea. With this prospect, how to invest will be much more important than what to invest. The biggest challenge for KOSPI is not the U.S. or China but rather the lack of earnings growth of listed Korean companies. The fact that the market has been range bound over the past three years is due to the KOSPI earnings disappointment during that period. KOSPI aggregate earnings have been stuck below 100 trillion won for the past three years. For the past two years, the expected earnings at the beginning of the year have been 120 trillion won. The actual earnings came in around 90 trillion won. For 2014, the expected earnings for KOSPI is once again at 120 trillion won. Whether the listed Korean companies can generate this expected earnings in 2014 or not will determine the path and trend for KOSPI. From the current vantage point, it does not look like this estimate can be accomplished. It looks like another year of bumpy ride for KOSPI. To make a decent risk-adjusted return in KOSPI, we will favor steady cash flow companies, will not pay up for cyclical growth expectations, and will question the “all is well”logic.
The main show in 2014 in Korea might not be the equity market. It may be the upcoming volatility in the bond market. Simply, there is much more money at risk to this rise in volatility in bonds. Also, this pickup in uncertainty is coming up after a long period of bull market in bonds. As such, rising bond market volatility will impact many financial industries such as insurance companies, brokerage companies and institutional and individual investors. We had a preview of this in 2013. But in 2014, we can expect a wider range of bond yield movement in Korea. With a long period of steadily declining bond yield being over, it looks like we have to accept and plan on a bond yield uncertainty. It seems like nothing will be too easy for Korean financial market investing in 2014.
Small steps with eyes on longer horizon
The modern global economy has not really gone through what we are going through currently, certainly not at this scale. As such, it is hard to pin down a scenario for the macroeconomic outlook and subsequent path for the financial markets. What we do know is that both the high level of liquidity and start of a new year bring us hope for a better financial market conditions. Although I hope this is the case, the analytical side of me says there are meaningful risk potholes on the 2014 road. To navigate the potentially volatile markets in Korea, the key strategy for 2014 is to analyze short-term events and issues while being mindful of longer-term topics. This is a tall order. Yet, we have to play with the cards that are dealt, not wishing we had some other cards to play with. As stated earlier, there are too many unknown interacting factors to conclude one scenario and take directional risk accordingly. Perhaps one of the hardest things about investing in 2014 is sorting out fiction versus realistic issues. This is not an easy task. As they say in Star Wars, “may the force be with you all” in 2014.