Are some Asian emerging markets beginning to price in a global recovery?

China’s economic reopening and budding cyclical recovery has bolstered sentiment towards in emerging markets (EM) in recent months. This is now well flagged.

The global growth outlook is recessionary, and global trade is slowing as developed market demand drops. EM manufacturing PMI is now contracting, and industrial production is falling. Consequently, the backdrop is somewhat gloomy for many EM export-driven markets.

And yet despite the gloom, South Korea and Taiwan, two markets where exports are a major contributor to GDP, have rallied 19% and 30% since 31 October, as at 17 February 2023. Over the same period the respective currencies have appreciated by 10% and 6% against the US dollar. These markets are beginning to anticipate a potential cyclical recovery.

Although optimism towards China’s reopening has been supportive, another important factor to monitor is the outlook for technology and the broader export sector, which is less clear. Uncertainty over the outlook for growth and inflation in the US and other developed markets persists. While South Korea and Taiwan have begun to anticipate a recovery this year, it may be that this does not come through until 2024.

Weak macroeconomic data

Taiwan’s economy recorded a weaker than expected slowdown in the fourth quarter, with GDP falling -0.9% year-on-year (y/y). South Korea’s economy contracted by -0.4% y/y over the same period, also by more than the consensus forecast.

High frequency data has also reflected the impact of slowing global growth. Exports from South Korea were down by almost 17% y/y in January and reached a 23-month low, while Taiwanese exports fell 21% y/y. Manufacturing PMI surveys, while off their cycle lows, remain in contraction territory (under 50) in both economies, and new export orders are negative.

The chart below shows the down cycle in South Korean exports, and broader EM export volume weakness. It suggests that the near-term outlook could remain challenging for EM manufacturers. However, South Korea’s economy may be ahead and markets are anticipating the cycle bottom.

South Korea and EM exports

Source: CPB, Refinitiv, Schroders Economics Group. 3 February 2023

Policy

Although inflation in both economies remains above target, at 5.7% y/y in South Korea and 2.7% y/y in Taiwan, it is at a lower level than in other EM, as illustrated below. Both central banks have been tightening their policy rates over the past 12 months. After a 25 basis points (bps) hike in January, the base rate in South Korea now sits at 3.5%, while the equivalent rate in Taiwan is now 1.75%.

Headline inflation (%)

Turkey’s annual headline inflation (58%) omitted from the figure. Source: Schroders, Refinitiv Datastream. Data as at 31 January 2022.

In terms of reforms, the South Korean Financial Services Commission is planning various measures which could support Korea’s inclusion in the FTSE World Government Bond Index, and reclassification to the MSCI World Index. For example, it is seeking to extend foreign exchange trading hours, widen participation, and improve the ease of registration for foreign investors.

Market accessibility issues relate to regulations introduced in the early 1900s. The goal of capital market reform from the local regulator is to attract greater foreign capital, and in turn narrow the valuation discount relative to other global markets. On the basis that the declared reforms proceed, MSCI could add South Korea to its watchlist for reclassification to developed markets in June. However, a possible upgrade would likely be dependent on the progress of legislative change, and may not follow for another year or two.

What the China reopening means for South Korea and Taiwan

The lifting of Covid-19 restrictions in China has bolstered market sentiment. Exporters in South Korea and Taiwan ought to benefit from some recovery in demand for manufactured goods, as well as intermediary goods such as semiconductors. South Korean and Taiwanese listed companies with operations in China should also experience a reduction in supply disruption and a normalisation in operations. This is set against a broader backdrop of slower global demand, however. In addition, ongoing US-China tensions, specifically around strategic competition in the technology sphere, remain a long-term risk (and are discussed below).

Tourism is another area which should benefit from China’s reopening. In 2019, South Korea and Taiwan attracted around 6 million and 2.7 million visitors respectively from mainland China. When Covid restrictions were initially lifted in China, South Korea introduced travel restrictions for inbound passengers from China, suspending short-term visas (a move which was reciprocated), but these have now been lifted.

Market and valuations

When assessing the market outlook for South Korea and Taiwan there are important nuances. While exports are key drivers of economic growth in both economies, exports as a share of GDP in Taiwan is highest at 70%, while the figure in South Korea has fallen to 36%. In Taiwan, more than half of this figure relates to electronics and other IT products. South Korean exports are more diversified. Similar nuance is present at the index level. The MSCI Taiwan is 70% IT, while the MSCI Korea Index is comparatively more diversified, and the weight of IT is lower at 45%. The South Korean market is also more cyclical than Taiwan, as a function of the stock constituents, rather than simply the sector categorisation.

From a valuations perspective, South Korea and Taiwan are slightly cheap relative to history. As the chart below shows, the two markets sit in the middle of the pack relative to other EM on a combined z-score basis.

Average (trailing P/E, P/E, P/B, dividend yield) (z-score¹)

Excludes UAE, Qatar, Saudi Arabia and Kuwait due to limited data history. ¹The z-score is a measure of how far valuations are from historical mean, calculated since January 2000.Source: Schroders, Refinitiv Datastream, MSCI, IBES, Schroders Strategic Research Unit. Data as at 31 January 2023.

Looking beneath the combined valuation figures, using the heatmap below, it is worth noting that South Korea’s score is impacted by the expensive forward price-earnings ratio. This reflects market expectations for some recovery in earnings, which is not yet factored into the consensus earnings forecast.

While it is important to review a range of valuation metrics, for a more cyclical, Value-oriented market such as South Korea, price-book provides a better gauge of cheapness. On this measure the market stands out. Taiwan in contrast is slightly less attractive on this measure, although as we noted earlier, it is not as cyclical a market as South Korea, and it is cheap on all three other measures.

EM valuation heatmaps - current z-scores¹

¹The z-score is a measure of how far valuations are from historical mean, calculated since January 2000.

Excludes UAE, Qatar, Saudi Arabia and Kuwait due to limited data history. Combined figure is an average of trailing P/E, 12-month forward P/E, P/B, and dividend yield. Source: Schroders, Refinitiv Datastream, MSCI, IBES, Schroders Strategic Research Unit. Data as at 31 January 2023.

Risks to the outlook

There are various risks to consider. In terms of the cyclical recovery, one important factor to monitor for both markets is the outlook for the US economy. If disinflation in the US abates, and the Federal Reserve (Fed) continues to tighten policy, this could extend the downturn in global trade, and see resilience or further strength in the US dollar.

Longer term risks stem primarily from geopolitics. For South Korea, tensions with the North have been rising again recently, after North Korean drones allegedly violated South Korean air space late last year. Its military alliance with the US has in the past contributed to tensions with China. Moreover, it is also a long-term strategic competitor to China in several industries, including technology. For Taiwan, US-China relations will remain a risk. The recent dispute between the US and China over alleged spy balloons, and the prospect of additional US export controls on technology to China are areas to monitor.

Our view

We have become more neutral in our outlook for Taiwanese equities. The technology sector offers a long-term growth opportunity and includes 5G, data centres, and the so-called internet-of-things. However, we have near-term cyclical concerns; the post Covid weakness in the DRAM semiconductor market has been more pronounced than in recent industry cycles. Recent company earnings results highlight that inventories are rising, but at the same time guidance is that the first half of this year should see the bottom of the cycle. Uncertainty prevails over the timing of the expected recovery. Given the strong market performance in recent months, there is significant scope for disappointment, but this could equally provide an opportunity.

We maintain a favourable view on South Korea. There is earnings risk as the global economy slows, but the weak cyclical outlook is increasingly discounted, despite recent performance. As we have discussed above and in a previous note, the market includes a diversified sector opportunity, and is home to various long-term thematic growth stocks in industries such as electric vehicle batteries.

Uncertainty in the outlook for global growth continues to cast a shadow over the timing of a cyclical recovery in these markets. While strong performance in recent months sets the stage for downside surprise, the direction of travel looks to be correct.