The iShares MSCI South Korea Capped ETF (NYSE:EWY) is the largest country-specific exchange-traded fund to track a basket of the most important Korean companies. Korea is long recognized as a high-tech manufacturing hub and innovator in various industries, including semiconductors. The economy has been pressured in recent years based on weaker cyclical trends and more volatile trade conditions in the Asia-Pacific region. While expectations into 2020 were for a rebound in growth, the emergence of the COVID-19 outbreak in Korea with the highest number of cases outside of China represents a new layer of uncertainty for the country’s macro outlook. We see the risk for a deeper economic slowdown with implications for the EWY ETF that may also be pressured by a depreciating Korean won.
COVID-19 Outbreak in South Korea
The coronavirus “COVID-19” outbreak that began in China has now spread to other parts of the world. South Korea with 1,766 confirmed cases as of February 27th is the current global hotspot with the most new number of new cases. Data shows that 43% of all cases outside of China have occurred in South Korea with the government taking emergency response measures, including school closures, while other countries have enacted travel restrictions. The situation poses a major disruption to the economy as its major cities and manufacturing centers are vital for economic activity.
There is still significant uncertainty as to the extent of the outbreak and when conditions can normalize. Beyond the public health crisis, a general fear among the population is likely to limit consumer activities and retail spending with people potentially avoiding public settings. We expect the impact to be widespread across confidence indicators, business sentiment, labor market dynamics, and the investing environment which in our opinion is bearish for Korean stocks and the EWY ETF.
The EWY ETF currently has 111 holdings in various sectors while relatively concentrated among technology stocks. Samsung Electronics Ltd (OTC:SSNLF) is the most important company in the country and plays a major role in the fund with a 24% weighting.
Samsung is indeed a major multinational electronics manufacturer with both a diversified product line and sales exposure to various countries. Nevertheless, 2019 revenues locally from Korea and the Chinese market together represented over 30% of the total business, highlighting the cyclical exposure to the region.
That’s the case with several other multinational holdings in the fund including chip manufacturer SK Hynix, Inc. (OTC:HXSCL), auto company Hyundai Motor (OTCPK:HYMLF), each with global operations and supply chains. That being said, financial services sector companies in the fund like Shinhan Financial Group (SHG) and KB Financial Group Inc. (KB) are more exposed to local economic and credit conditions.
Among corresponding shares that trade on a U.S. exchange as an ADR, we highlight that several core holdings of EWY have already sold off in recent weeks and may have more downside ahead. While EWY is down about 10% year to date in 2020, stocks with heavy exposure to the domestic economy including the aforementioned banks SHG and KB are down more significantly each at 28% and 22% year to date, respectively. The performance of Korean stocks thus far suggests a level of risk aversion and investors taking the risks seriously.
Korea Macro Outlook
South Korea’s Central Bank, ‘The Bank of Korea’ just released its latest economic outlook with data through February 2020. The group is forecasting 2020 GDP growth of 2.1% while seeing a potential rebound in 2021 to 2.4%. Keep in mind these estimates are vulnerable to the ongoing and fast-developing situation of the COVID-19 outbreak, which is mentioned as representing a key downside risk.
Thus far, the official government projection considers the impact as temporary and thinks the economy can recover on the basis of fiscal and monetary stimulus. From the report:
After a temporary slowdown due to the negative impacts from COVID-19, the domestic economy is expected to recover as private consumption and exports rebound amid continued fiscal expansion and a recovery in facilities investment.
(Source: Bank of Korea)
The context here is that the economy was already weak since 2019 with GDP growth of 2.0% compared to a 2.8% rate in 2018 and 3.2% in 2017, based on declining domestic demand and private consumption dynamics. Construction and residential buildings are cited as a weak area of the economy. The hope is that the current situation only leads to temporary or transitory impacts and the economy can rebound going forward.
Going into 2020, a more positive outlook was based on an expectation that a recovery in global trade, given the progress in the U.S.-China trade dispute, was set to improve conditions and support a recovery in Korean exports going forward. It’s evident that the latest developments, unfortunately, are now set to derail this anticipated recovery. It’s likely the forecast made above based on data prior to the outbreak gaining momentum in Korea now faces downside revisions.
We also note that inflation, while still relatively subdued, has trended higher in recent months considering the current CPI rate of 1.5% year over year in January, up from a deflationary level of -0.4% y/y in September. This is important as there is a risk that trade disruptions and global supply chain bottlenecks can represent renewed inflationary pressures despite weaker demand pressures and the ongoing output gap. The Central Bank with a current policy rate at 1.25% may be challenged to cut rates to support growth if inflation becomes a concern. Either way, the trends are bearish for the Korean won in our opinion.
Recognizing that the EWY ETF based on underlying stocks priced in the local currency of the Korean won, the risk here is that investors are exposed to FX risks. This goes both ways as an appreciation of the won would drive returns when converted to U.S. dollars. That being said, we think the risk is for a further depreciation as the won is now trading near a record low against the U.S. dollar with trends pointing to more weakness. The current exchange rate of KRW 1212 per USD represents a depreciation of nearly 15% from early 2018.
The setup here is that a combination of weaker growth, macro uncertainties, dovish Korean central bank monetary policy, fiscal stimulus adds up to bearish trends on the currency. A 5-10% depreciation of the won from current levels would imply a corresponding downside move in the EWY ETF, all else equal.
EWY Analysis and Forward-Looking Commentary
In many ways, EWY is a macro play as the major stocks in the fund are multinationals with significant exposure to trends in global trade and cyclical demand. The portfolio of stocks could benefit from a rebound of global growth expectations and renaissance of investment sentiment should the virus outbreak be contained faster than expected. On the other hand, a deterioration in macro conditions or a more serious widespread outbreak may result in a reset of the economic outlook representing deeper downside risks.
Our base case is that beyond the still-developing situation and the uncertain outcome of the epidemic, the Korean economy is likely to face a longer-lasting negative impact. If the Central Bank chooses to take a more dovish approach to monetary policy, we expect the Korean won to face more downside coupled with already strained fiscal position by the government and weaker external account data suggesting the local won may be pressured adding to the downside for the EWY ETF.
Following already weakening economic trends in Korea with a decelerating economy since 2017, the latest COVID-19 outbreak represents a new risk factor with widespread implications not only in the local economy but also in global trading partners. The EWY ETF includes several multinational corporations exposed to global cyclical trends that face higher uncertainty related to their operating environment. We expect the underlying holdings in the fund directly connected to the local economy to face the increasing pressure from declining consumer sentiment and business confidence. Macro trends also point to a further depreciation of the Korean won which may further pressure returns for the EWY ETF. Take a look at the fund prospectus for a full list of risks and disclosures.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.