EWY - EWY: The Korean Recovery Is Just Getting Started

2023-04-16 03:57:56 ET

Summary

• With the Korean macro backdrop finally turning a corner, the iShares MSCI South Korea ETF has kicked off the year with a bang.
• The long EWY trade is not short of fundamental tailwinds from here, including on the exports side due to the Chinese reopening and a potential monetary policy pivot.
• Valuations remain very reasonable, leaving ample room for EWY to re-rate further.

The pickup in Korean equities this year has been positive, reflecting growing optimism that economic growth will pick up in the latter half of the year. While Q4 saw GDP contracting for the first time since the COVID-impacted years, the China reopening tailwind has boosted hopes of an eventual recovery in key export-driven growth industries like semiconductors. Also encouraging is the consumer outlook, with inflation under control and gradually easing towards the 2% target. This needs to be weighed against the prospect of a growth slowdown in the US/EU, though, as export headwinds from these regions could weigh on earnings. But it could also tip the policy trade-off toward stimulating growth (vs. price stability); a more accommodative stance should boost equity valuations and potentially also cushion an earnings slowdown. Given the composition of the iShares MSCI South Korea ETF ( EWY ) skews toward tech and cyclical end-markets like steel and autos, the fund should see outsized benefits from a policy pivot. Also worth keeping an eye on is the pending inclusion into the FTSE Russell World Government Bond Index; increased sovereign bond inflows would mean a structurally lower cost of capital and higher equity valuations.

Fund Overview – A Portfolio of South Korean Champions

The US-listed iShares MSCI South Korea ETF seeks to track, before fees and expenses, the performance of the MSCI Korea 25/50 Index, which comprises large and mid-cap Korean equities (~85% of the free float-adjusted market cap). The ETF held ~$3.5bn of net assets at the time of writing and charged a 0.6% expense ratio, a premium to its closest comparable, the Franklin FTSE South Korea ETF ( FLKR ). A summary of key facts about the ETF is listed in the graphic below:

The fund is spread across 103 holdings, with the largest sector allocation going to Information Technology at 34.6%, followed by Industrials at 12.2% and Materials at 11.2%. Other >10% sector allocations include Consumer Discretionary (10.8%) and Financials (10.1%). On a cumulative basis, the top five sectors accounted for ~79% of the total portfolio, making EWY a relatively concentrated Asian ETF from a sector perspective. In line with the cyclical portfolio composition, the fund's equity beta is relatively high at 1.2, so it should outpace an upswing in the broader markets (and vice versa).

From a single-stock perspective, the ETF also stands out for its exposure to tech giant Samsung Electronics ( SSNLF ) at 22.0%. In contrast, no other holding exceeds the 5% threshold. The second largest holding is semiconductor company SK Hynix ( HXSCF ) at 4.7%, followed by battery and electronic materials manufacturer Samsung SDI ( SSDIY ) at 4.1% of the portfolio. Rounding out the top five are LG Chemical ( LGCLF ) at 3.8% and steel-making company POSCO ( PKX ) at 2.9%. In total, the top five holdings account for ~37% of the overall portfolio; outside of the big Samsung Electronics stake, EWY is fairly well-diversified from a single-stock standpoint. At ~9.1x earnings and <1x book value, the fund screens inexpensively relative to the underlying quality and growth potential of its holdings.

Fund Performance – A Long-Term Compounder Despite the Recent Turbulence

On a YTD basis, the ETF has risen by 14.3% and has compounded at an impressive 6.1% pace in market price and NAV terms since its inception in 2000. The fund has been going through a rough patch of late, however, with last year's 26.7% drawdown coming on the heels of a -7.6% decline in 2021. While the +39.7% return in 2020 has pulled up the fund's three-year return to 10.6%, the five and ten-year returns remain underwhelming at -2.3% and 2.1%, respectively. Given the fund's high-beta exposure to tech/semiconductors and materials, investors should be prepared for more volatility going forward.

The annual distribution is income-driven, though the fund's holdings in cyclical, capital-intensive names have weighed on the through-cycle cash return. At a trailing twelve-month yield of 1.1% (1.4% on a 30-day basis), EWY isn't an ETF for income investors. Instead, investors should view the income portion as a supplement to the earnings growth potential of the fund's portfolio holdings.

The Monetary Policy Stance is Turning Accommodative

At the Bank of Korea's latest policy meeting , its policy rate was unsurprisingly kept on hold at 3.5%. More interesting was the shift in tone - the decision was not only unanimous this time (vs. one dissenting vote at the last meeting), but the forward-looking section of the policy statement also incorporated a dovish acknowledgment of the emerging disinflation domestically. Unlike the West, where 'core' inflation has been somewhat sticky, South Korea's increased labor participation rates among the older population, as well as declining corporate profits, have mitigated wage-price spiral concerns.

Another dovish sign was the Governor noting that policy rates have been restrictive to domestic demand and property markets per the BOK press conference remarks. Given the higher likelihood of an external demand slowdown this year and a further cooling in inflation, a policy pivot toward growth (over price stability) could well be on the cards. A sooner-than-expected shift towards accommodative monetary policy would be bullish for equities; high-beta plays like EWY should outperform against this backdrop.

Korean Exports Boost Ahead as the China Reopening Enters its Second Inning

China's reopening and the country's consumption-led recovery this year have provided a much-needed boost to the global economy. With Korea also suffering an export-driven slowdown in recent months, mainly from weaker developed markets' demand, the China offset is much needed. That said, March data showed Korea's exports had reversed prior months' declines in March (see chart below), as a strong rebound in semiconductor exports outweighed weakness in commodity and non-chip exports.

Of note, the key contributors to the strong March report were Hong Kong and Vietnam for semiconductor exports, while exports to mainland China have yet to fully recover. While the latter would seem to contradict the China reopening thesis, context is important – as most exports to China are capital and intermediary goods (vs. consumer goods), it comes as no surprise that China's current consumption-led recovery has yet to be a major tailwind. This should change over time, though, as a pickup in China's consumer and final goods demand will inevitably be followed by an upswing in intermediary goods as well. Thus, expect a more meaningful China-driven recovery for Korean final and intermediary exports later this year or next year.

The Korean Recovery is Just Getting Started

The tech-heavy EWY fund has risen by a fair bit this year but remains a long way from recovering the losses seen over the last two years. With a Korean export-driven recovery beginning to materialize, particularly in semiconductors, all signs point to a pickup in H2. Inflation has also largely subsided, clearing the path for BOK policy to turn accommodative should an external slowdown materialize. The equity valuation uplift from looser policy domestically and in the West should help to cushion any earnings slowdown, with high-beta funds like EWY poised to outperform. In addition to the fundamental recovery, a technical re-rating could also be on the horizon should Korea's capital market reforms accelerate its entry into the FTSE Russell World government bond index.

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