Wishful thinking amid both positives and risks

By Park Chong-hoon

The KOSPI has shown some recovery since July, recouping some of the losses of this year. The index fell 22.2 percent up until June, one-year Korea Treasury Bond (KTB) yields rose to 3 percent on June 30 and have fallen since, suggesting that the policy rate is likely to peak around the 3 percent level. The market also no longer expects the Fed to hike the interest rate aggressively given the economic slowdown. Further, market expectations appear to be based on the expectation that U.S. inflation has already peaked.

However, this wishful thinking appears premature, and we see downside risks from the raging Russia-Ukraine war, still-elevated European gas prices, elevated U.S. inflation (8.5 percent year-on-year), and China's still-tenuous recovery.

Although we see a strong possibility of a Federal Open Market Committee (FOMC) pause in raising the interest rate in the fourth quarter (Q4), we believe the market pricing of rate cuts in 2023 is premature. We think the FOMC is unlikely to shift quickly from an aggressive hiking cycle in 2022, amid the worst inflation in decades, to reduce rates in 2023. After struggling to control inflation and expectations, we think the FOMC will be unwilling to declare a quick victory over inflation and cut rates again. Then, we expect an extended pause by the FOMC in 2023.

Significant risks remain: major economies still face daunting economic headwinds; Europe could stumble further under the weight of an energy crisis in winter; commodity prices could surge anew; and while inflation may have peaked, it may not return to pre-COVID-19 levels. But a potential softening of global inflation rates may remove the tail risk of ongoing, larger-than-expected rate hikes from the FOMC and other global central banks.

China's economic recovery could stall under deteriorating consumer sentiment and its zero-COVID policy lockdowns. In light of weaker-than-expected growth in July, we downgraded our forecasts for China's Q3, Q4 and 2022 annual GDP growth to 3.2 percent year-on-year, 4.8 percent year-on-year and 3.3 percent year-on-year, respectively, from 5.3 percent, 5.9 percent and 4.1 percent, previously. We expect the path to China's economic recovery to be a slog, as local governments are likely be cautious about relaxing business restrictions ahead of the 20th Party Congress due to fears of COVID-19 resurgences.

Geopolitical tensions are rising, and they pose headwinds to Korea as well. The Asia market witnessed volatility amid Nancy Pelosi's visit to Taiwan, with the China Shanghai Composite Index closing down 2.26 percent from the previous trading day. The Hong Kong Hang Seng Index and the Taiwan Capitalization Weighted Stock Index also fell 2.36 percent and 1.56 percent, respectively. U.S.-China tensions are also likely to continue through trade conflicts or building global supply chains of semiconductors, which would hurt Korea's exports and financial market.

The domestic environment also has its challenges. While real economic data remain robust, sentiment has started to weaken. Production and employment are still showing solid growth, while concerns about a future recession are rising (as evidenced by the decline in the leading index).

Employment is usually a lagging indicator. While production and employment are both still expanding due to pent-up demand following COVID-19 disruptions, this momentum may fade in the coming months. While we think upside and downside risks to Korea's economy are balanced, for now, downside risks are set to increase due to the negative impact of China's lockdowns and the prolonged war in Ukraine.

We believe the Bank of Korea (BOK) will continue to hike interest rates amid the Fed's hiking cycle and rising inflation, exacerbated by the weakness of the Korean won. We expect the BOK to deliver another 0.5 percent of hikes this year after its front-loaded 0.5 percent move in July to tame expected inflation and align with global central banks. The BOK needs to move in line with other central banks, in our view, as a dovish stance would risk weakening the Korean won further, driving inflation higher.

We acknowledge the risk of more than 0.5 percent in hikes for the rest of 2022, depending on the pace of Fed tightening. BOK Governor Rhee Chang-yong has said that the BOK needs to watch capital flows and the Korean won exchange rate as the Fed further withdraws liquidity. More rate hikes could be required if the Korean won weakness threatens to push prices higher via imported inflation.

On the positive side, foreign selling of Korean equities is slowing, Korean retail investors' foreign equity purchases are recovering, and foreign asset purchases by Korea's National Pension Service (NPS) fund are picking up, after having weighed on the Korean won. Also, with the U.S. Consumer Price Index (CPI) report a month away and the European winter several months away, risky assets may have enough time to recover some of their lost ground. The U.S. dollar weakness would help smooth the path to better performance.

While the market appears to have already priced in this positive sentiment in recent days, we will stay cautious amid the aforementioned risks.

Park Chong-hoon (ChongHoon.Park@sc.com) currently heads the Korea Research Team at Standard Chartered Korea. Before joining the bank, he worked as a senior research fellow and head of telecommunication policy at the Korea Information Society Development Institute (KISDI).