South Korea

Highlights The US Climate Prediction Center gives ~ 70% odds another La Niña will form in the August – October interval and will continue through winter 2021-22. This will be a second-year La Niña if it forms, and will raise the odds of a repeat of last winter's cold weather in the Northern Hemisphere.1 Europe's natural-gas inventory build ahead of the coming winter remains erratic, particularly as Russian flows via Ukraine to the EU have been reduced this year. Russia's Nord Stream 2 could be online by November, but inventories will still be low. China, Japan, South Korea and India  – the four top LNG consumers in Asia  – took in 155 Bcf of the fuel in June. A colder-than-normal winter would boost demand. Higher prices are likely in Europe and Asia (Chart of the Week). US storage levels will be lower going into winter, as power generation demand remains stout, and the lingering effects from Hurricane Ida reduce supplies available for inventory injections. Despite spot prices trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu – we are going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. Feature Last winter's La Niña was a doozy. It brought extreme cold to Asia, North America and Europe, which pulled natural gas storage levels sharply lower and drove prices sharply higher as the Chart of the Week shows. Natgas storage in the US and Europe will be tight going into this winter (Chart 2). Europe's La Niña lingered a while into Spring, keeping temps low and space-heating demand high, which delayed the start of re-building inventory for the coming winter.  In the US, cold temps in the Midwest hampered production, boosted demand and caused inventory to draw hard. Chart of the WeekA Return Of La Niña Could Boost Global Natgas Prices A Return Of La Niña Could Boost Global Natgas Prices A Return Of La Niña Could Boost Global Natgas Prices Chart 2Europe, US Gas Stocks Will Be Tight This Winter NatGas: Winter Is Coming NatGas: Winter Is Coming Summer in the US also produced strong natgas demand, particularly out West, as power generators eschewed coal in favor of gas to meet stronger air-conditioning demand. This is partly due to the closing of coal-fired units, leaving more of the load to be picked up by gas-fired generation (Chart 3). The EIA estimates natgas consumption in July was up ~ 4 Bcf/d to just under 76 Bcf/d. Hurricane Ida took ~ 1 bcf/d of demand out of the market, which was less than the ~ 2 Bcf/d hit to US Gulf supply resulting from the storm.  As a result, prices were pushed higher at the margin. Chart 3Generators Prefer Gas To Coal NatGas: Winter Is Coming NatGas: Winter Is Coming US natgas exports (pipeline and LNG) also were strong, at 18.2 Bcf/d in July (Chart 4). We expect US LNG exports, in particular, to resume growth as the world recovers from the COVID-19 pandemic (Chart 5). This strong demand and exports, coupled with slightly lower supply from the Lower 48 states – estimated at ~ 98 Bcf/d by the EIA for July (Chart 6) – pushed prices up by 18% from June to July, "the largest month-on-month percentage change for June to July since 2012, when the price increased 20.3%" according to the EIA. Chart 4US Natgas Exports Remain Strong US Natgas Exports Remain Strong US Natgas Exports Remain Strong Chart 5US LNG Exports Will Resume Growth NatGas: Winter Is Coming NatGas: Winter Is Coming Chart 6US Lower 48 Natgas Production Recovering US Lower 48 Natgas Production Recovering US Lower 48 Natgas Production Recovering Elsewhere in the Americas, Brazil has been a strong bid for US LNG – accounting for 32.3 Bcf of demand in  June – as hydroelectric generation flags due to the prolonged drought in the country. In Asia, demand for LNG remains strong, with the four top consumers – China, Japan, South Korea, and India – taking in 155 Bcf in June, according to the EIA. Gas Infrastructure Ex-US Remains Challenged A combination of extreme cold weather in Northeast Asia, and a lack of gas storage infrastructure in Asia generally, along with shipping constraints and supply issues at LNG export facilities, led to the Asian natural gas price spike in mid-January.2 Very cold weather in Northeast Asia, drove up LNG demand during the winter months. In China, LNG imports for the month of January rose by ~ 53% y-o-y (Chart 7).3 The increase in imports from Asia coincided with issues at major export plants in Australia, Norway and Qatar during that period. Chart 7China's US LNG Exports Surged Last Winter, And Remain Stout Over The Summer NatGas: Winter Is Coming NatGas: Winter Is Coming Substantially higher JKM (Japan-Korea Marker) prices incentivized US exporters to divert LNG cargoes from Europe to Asia last winter. The longer roundtrip times to deliver LNG from the US to Asia – instead of Europe – resulted in a reduction of shipping capacity, which ended up compounding market tightness in Europe. Europe dealt with the switch by drawing ~ 18 bcm more from their storage vs. the previous year, across the November to January period. Countries in Asia - most notably Japan – however, do not have robust natural gas storage facilities, further contributing to price volatility, especially in extreme weather events. These storage constraints remain in place going into the coming winter. In addition, there is a high probability the global weather pattern responsible for the cold spells around the globe that triggered price spikes in key markets globally – i.e., a second La Niña event – will return. A Second-Year La Niña  Event The price spikes and logistical challenges of last winter were the result of atmospheric circulation anomalies that were bolstered by a La Niña event that began in mid-2020.4 The La Niña is characterized by colder sea-surface temperatures that develops over the Pacific equator, which displaces atmospheric and wind circulation and leads to colder temperatures in the Northern Hemisphere (Map 1). Map 1La Niña Raises The Odds Of Colder Temps NatGas: Winter Is Coming NatGas: Winter Is Coming The IEA notes last winter started off without any exceptional deviations from an average early winter, but as the new year opened "natural gas markets experienced severe supply-demand tensions in the opening weeks of 2021, with extremely cold temperature episodes sending spot prices to record levels."5 In its most recent ENSO update, the US Climate Prediction Center raised the odds of another La Niña event for this winter to 70% this month. If similar conditions to those of the 2020-21 winter emerge, US and European inventories could be stretched even thinner than last year, as space-heating demand competes with industrial and commercial demand resulting from the economic recovery. Global Natgas Supplies Will Stay Tight JKM prices and TTF (Dutch Title Transfer Facility) prices are likely to remain elevated going into winter, as seen in the Chart of the Week. Fundamentals have kept markets tight so far. Uncertain Russian supply to Europe will raise the price of the European gas index (TTF). This, along with strong Asian demand, particularly from China, will keep JKM prices high (Chart 8). The global economic recovery is the main short-term driver of higher natgas demand, with China leading the way. For the longer-term, natural gas is considered as the ideal transition fuel to green energy, as it emits less carbon than other fossil fuels. For this reason, demand is expected to grow by 3.4% per annum until 2035, and reach peak consumption later than other fossil fuels, according to McKinsey.6 Chart 8BCAs Brent Forecast Points To Higher JKM Prices BCAs Brent Forecast Points To Higher JKM Prices BCAs Brent Forecast Points To Higher JKM Prices Spillovers from the European natural gas market impact Asian markets, as was demonstrated last winter. Russian supply to Europe – where inventories are at their lowest level in a decade – has dropped over the last few months. This could either be the result of Russia's attempts to support its case for finishing Nord Stream 2 and getting it running as soon as possible, or because it is physically unable to supply natural gas.7 A fire at a condensate plant in Siberia at the beginning of August supports the latter conjecture. The reduced supply from Russia, comes at a time when EU carbon permit prices have been consistently breaking records, making the cost of natural gas competitive compared to more heavy carbon emitting fossil fuels – e.g., coal and oil – despite record breaking prices. With Europe beginning the winter season with significantly lower stock levels vs. previous years, TTF prices will remain volatile. This, and strong demand from China, will support JKM prices. Investment Implications Natural gas prices are elevated, with spot NYMEX futures trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu. Our analysis indicates prices are justifiably high, and could – with the slightest unexpected news – move sharply higher. Because natgas is, at the end of the day, a weather market, we favor low-cost/low-risk exposures. In the current market, we recommend going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. This is the trade we recommended on 8 April 2021, at a lower level, which was stopped out on 12 August 2021 with a gain of 188%.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Earlier this week, Saudi Aramco lowered its official selling price (OSP) by more than was expected – lowering its premium to the regional benchmark to $1.30/bbl from $1.70/bbl – in what media reports based on interviews with oil traders suggest is an attempt to win back customers electing not to take volumes under long-term contracts. This is a marginal adjustment by Aramco, but still significant, as it shows the company will continue to defend its market share. Pricing to Northwest Europe and the US markets is unchanged. Aramco's majority shareholder, the Kingdom of Saudi Arabia (KSA), is the putative leader of OPEC 2.0 (aka, OPEC+) along with Russia. The producer coalition is in the process of returning 400k b/d to the market every month until it has restored the 5.8mm b/d of production it took off the market to support prices during the COVID-19 pandemic. We expect Brent crude oil prices to average $70/bbl in 2H21, $73/bbl in 2022 and $80/bbl in 2023. Base Metals: Bullish Political uncertainty in Guinea caused aluminum prices to rise to more than a 10-year high this week (Chart 9). A coup in the world’s second largest exporter of bauxite – the main ore source for aluminum – began on Sunday, rattling aluminum markets. While iron ore prices rebounded primarily on the record value of Chinese imports in August, the coup in Guinea – which has the highest level of iron ore reserves – could have also raised questions about supply certainty. This will contribute to iron-ore price volatility. However, we do not believe the coup will impact the supply of commodities as much as markets are factoring, as coup leaders in commodity-exporting countries typically want to keep their source of income intact and functioning. Precious Metals: Bullish Gold settled at a one-month high last Friday, when the US Bureau of Labor Statistics released the August jobs report. The rise in payrolls data was well below analysts’ estimates, and was the lowest gain in seven months. The yellow metal rose on this news as the weak employment data eased fears about Fed tapering, and refocused markets on COVID-19 and the delta variant. Since then, however, the yellow metal has not been able to consolidate gains. After falling to a more than one-month low on Friday, the US dollar rose on Tuesday, weighing on gold prices (Chart 10). Chart 9 Aluminum Prices Recovering Aluminum Prices Recovering Chart 10 Weaker USD Supports Gold Weaker USD Supports Gold       Footnotes 1      Please see the US Climate Prediction Center's ENSO: Recent Evolution, Current Status and Predictions report published on September 6, 2021. 2     Please see Asia LNG Price Spike: Perfect Storm or Structural Failure? Published by Oxford Institute for Energy Studies. 3     Since China LNG import data were reported as a combined January and February value in 2020, we halved the combined value to get the January 2020 amount. 4     Please see The 2020/21 Extremely Cold Winter in China Influenced by the Synergistic Effect of La Niña and Warm Arctic by Zheng, F., and Coauthors (2021), published in Advances in Atmospheric Sciences. 5     Please see the IEA's Gas Market Report, Q2-2021 published in April 2021. 6     Please see Global gas outlook to 2050 | McKinsey on February 26, 2021. 7     Please see ICIS Analyst View: Gazprom’s inability to supply or unwillingness to deliver? published on August 13, 2021.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights We continue to recommend that dedicated EM equity portfolio investors overweight Korean equities. Overweighting the KOSPI within an EM equity portfolio is in line with our long-term theme of favoring global industrial stocks and is consistent with our medium-term strategy of favoring global industrials over global materials. Yet, the risk-reward for the KOSPI index in absolute terms is not yet attractive. Despite long-term positives for the semiconductor industry, near-term softness in new orders for memory chips is likely to occur. This will limit the upside in Korean tech stocks. Feature Korean share prices have been moving sideways in recent months. Is this the beginning of a major downtrend or just a consolidation before another upleg? Chart 1 illustrates that margin loans for security purchases and the number of equity transactions in Korea have been surging. In addition, retail investors continue to increase their equity holdings, i.e., they have remained net buyers (Chart 2). In short, the retail mania in Korean stocks is persisting.  Chart 1Retail Mania In Korean Stocks Persists Strategy For Korean Equities Strategy For Korean Equities Chart 2Korean Equities: Retail Investor Purchases Have Driven The Rally Strategy For Korean Equities Strategy For Korean Equities     It is impossible to determine when this retail-driven mania will subside. So long as corporate profits continue expanding, Korean share prices could correct amidst possible retail selling without necessarily collapsing. In such a scenario, odds are that domestic institutional and foreign investors will step in and buy on a meaningful dip in stock prices. Our investment strategy is as follows: in absolute terms, the risk-reward for the KOSPI index is not attractive. Significant upside in share prices from current levels is only possible if the retail-driven equity mania pushes stock valuations to very expensive levels. In relative terms, however, we continue recommending an overweight position in this bourse within an EM equity portfolio. Importantly, Korean stocks are likely to outperform the EM benchmark in any market scenario. The Semiconductor Cycle: An Inflection Point? The recent softness in DRAM (memory semiconductor) prices and the DXI (a DRAM revenue proxy) explains the correction in Korea’s semiconductor stocks that make up a large proportion of this bourse’s market cap (Chart 3). Are we witnessing a top in the semiconductor cycle? The structural and cyclical demand for semiconductors from servers, automation, and autos remains positive as we argued in our special report on semiconductors from August 20th of last year (Chart 4). Chart 3Korean Tech Stocks And DRAM Revenue Proxy Strategy For Korean Equities Strategy For Korean Equities Chart 4There Is Pent-Up Demand For Semiconductors Strategy For Korean Equities Strategy For Korean Equities   However, near-term downside risks cannot be ruled out: Rising bitcoin prices encourage mining and promote demand for memory chips (Chart 5). The plunge in bitcoin prices and a crackdown on bitcoin mining and transactions in China and in some other countries could lead to a decline in bitcoin mining investments. The latter will herald a moderation in demand for memory chips worldwide. Another reason for a potential slump in DRAM demand is contracting smartphone sales in China (Chart 6). These account for 26% of global smartphone sales. Chart 5Does Bitcoin Drive DRAM Prices? Strategy For Korean Equities Strategy For Korean Equities Chart 6Smartphone Sales Have Been Dismal In China Strategy For Korean Equities Strategy For Korean Equities Chart 7China Has Been Accumulating Semiconductor Inventories Strategy For Korean Equities Strategy For Korean Equities In addition, China has been aggressively building semiconductor inventories since early 2019 amid the escalating US-China confrontation which is especially intense pertaining to the semiconductor industry (Chart 7). Given that such stockpiling is driven by non-economic aims, it is impossible to know how long this restocking process will last. That said, however, it is reasonable to expect some moderation in the pace of semiconductor stockpiling in China. Global personal computer (PC) shipments have skyrocketed in the past 12 months due to the work-from-home phenomenon (Chart 8). As the US and European economies reopen and employees make a partial return to offices, it is reasonable to expect a decline in PC sales and ultimately demand for memory chips. Finally, there has recently been some softness in the Taiwanese semiconductor industry data as shown in Chart 9. Chart 8Personal Computer Shipments Have Benefited From Work From Home Strategy For Korean Equities Strategy For Korean Equities Chart 9A Soft Spot In The Taiwanese Semiconductor Industry? Strategy For Korean Equities Strategy For Korean Equities   Bottom Line: Despite long-term positives for the semiconductor industry, the occurrence of near-term softness in new memory chip orders is likely. This will cap the upside in Korean tech stocks that make up 40% of the KOSPI index. The KOSPI As An Industrial Play Within The EM Benchmark One of our major long-term themes is to be bullish on global industrial stocks. Global industrial companies’ share prices will appreciate and outperform the global equity benchmark in the coming years. This bull market will be driven by: benefits from strong infrastructure investments in the US and decarbonization initiatives globally; cost reductions and wider profit margins due to the widespread deployment of robotics; the role of industrials serving as inflation protection for investment portfolios.1 However, the market cap of industrial companies in the MSCI EM equity benchmark is small at just 5%. Plus, these industrial companies have performed substantially worse than their DM peers over the past ten years. The reasons behind such disappointing performance are partially related to corporate governance in EM industrial companies. So, how then does one play the bullish industrials theme within the EM benchmark? The KOSPI represents a good proxy for industrials within the EM benchmark. Even though the market cap of industrial companies in the MSCI Korea index is only 5%, large weights in Samsung and automakers render the Korean bourse a good proxy play on a global industrial boom. Chart 10The KOSPI As An Industrial Play Within The EM Benchmark Strategy For Korean Equities Strategy For Korean Equities Notably, Korea’s relative equity performance against the EM benchmark correlates well with trends in global industrials relative to global non-TMT stocks (Chart 10). We continue recommending the long global industrial/short global materials as a cyclical strategy for global equity portfolios. The mirror image of this strategy in the EM equity universe would be long KOSPI/short EM index. The basis for favoring global industrials against global materials is a bet on the industrial boom in the US/DM and on a slowdown in China’s construction and infrastructure sectors. The latter two are vital to bulk commodity prices, and thereby, to global material stocks. Bottom Line: Overweighting the KOSPI within an EM equity portfolio is in line with our long-term theme of favoring global industrial stocks and is akin to our medium-term strategy of favoring global industrials over global materials. Korea’s Exposure To China Chart 11Korea's Export Destinations Strategy For Korean Equities Strategy For Korean Equities As the largest importer of Korean exports, China’s impending slowdown poses a risk to Korean exports and the absolute performance of the KOSPI. However, the bourse will likely outperform the EM equity benchmark on the basis that Korean exports are also meaningfully exposed to the US and the EU. The US and the EU combined account for 25% of Korean exports while China accounts for 26% (Chart 11). While Korean exports to China are large, the equity market cap of those export sectors most exposed to the mainland only make up a small share of the Korean stock market. Namely, the materials and industrials sectors, make up only 15% of the MSCI Korea equity index. What’s more, Chinese imports of consumer goods from Korea are far less vulnerable than Chinese imports of commodities and capital goods. The latter are more sensitive to China’s credit cycle than consumer goods. Hence, the Korean bourse and the currency are less vulnerable than those economies that ship raw materials and industrial goods to China. Investment Recommendations Chart 12Analysts Have Been Downgrading Korean Tech EPS But Not Overall EM EPS Estimates Strategy For Korean Equities Strategy For Korean Equities We continue to recommend that dedicated EM equity portfolio investors overweight Korean equities. Equity analysts have commenced downgrading their corporate earnings estimates for Korean technology companies but there has been little downgrade in their overall EM EPS profits projections (Chart 12). From a contrarian perspective, these EPS projections warrant overweighing the Korean index with its very large weight in technology. Korea’s exchange rate will be driven by trends in the broad trade-weighted US dollar. In the coming months, we expect the greenback to rebound. Thus, tactically, the won will likely correct. In the long run, risks to the US dollar are to the downside, and, hence, the Korean won will appreciate against the greenback. Local currency government bond yields move in tandem with US Treasurys yields. The next large move will be higher US and Korean government bond yields. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Vanessa Wong Ee Shan Research Associate vanessaw@bcaresearch.com   Footnotes 1 We will elaborate on these reasons in much more detail in a forthcoming report.

Highlights Market-based geopolitical analysis is about identifying upside as well as downside risk. So far this year upside risks include vaccine efficacy, coordinated monetary and fiscal stimulus, China’s avoidance of over-tightening policy, and Europe’s stable political dynamics. Downside risks include vaccine rollout problems, excessive US stimulus, a Chinese policy mistake, and traditional geopolitical risks in the Taiwan Strait and Persian Gulf. Financial markets may see more turmoil in the near-term over rising bond yields and the dollar bounce. But the macro backdrop is still supportive for this year. We are initiating and reinitiating a handful of trades: EM currencies ex-Brazil/Turkey/Philippines, the BCA rare earth basket, DM-ex-US, and the Trans-Pacific Partnership markets, and global value plays. Feature Chart 1Bond Yield Spike Threatens Markets In Near Term Bond Yield Spike Threatens Markets In Near Term Bond Yield Spike Threatens Markets In Near Term Investors hear a lot about geopolitical risk but the implication is always “downside risk.” What about upside risks? Where are politics and geopolitics creating buying opportunities? So far this year, on the positive side, the US fiscal stimulus is overshooting, China is likely to avoid overtightening policy, and Europe’s political dynamics are positive. However, global equity markets are euphoric and much of the good news is priced in. On the negative side, the US stimulus is probably too large. The output gap will be more than closed by the Biden administration’s $1.9 trillion American Rescue Plan yet the Democrats will likely pass a second major bill later this year with a similar amount of net spending, albeit over a longer period of time and including tax hikes. The countertrend bounce in the dollar and rising government bond yields threaten the US and global equity market with a near-term correction. The global stock-to-bond ratio has gone vertical (Chart 1). Meanwhile Biden faces immediate foreign policy tests in the Taiwan Strait and Persian Gulf. These two are traditional geopolitical risks that are once again underrated by investors. The near term is likely to be difficult for investors to navigate. Sentiment is ebullient and likely to suffer some disappointments. In this report we highlight a handful of geopolitical opportunities and offer some new investment recommendations to capitalize on them. Go Long Japan And Stay Long South Korea China’s stimulus and recovery matched by global stimulus and recovery have led to an explosive rise in industrial metals and other China-sensitive assets such as Swedish stocks and the Australian dollar that go into our “China Play Index” (Chart 2). Chart 2China Plays Looking Stretched (For Now) China Plays Looking Stretched (For Now) China Plays Looking Stretched (For Now) While a near-term pullback in these assets looks likely, tight global supplies will keep prices well-bid. Moreover long-term strategic investment plans by China and the EU to accelerate the technology race and renewable energy are now being joined by American investment plans, a cornerstone of Joe Biden’s emerging national policy program. We are long silver and would buy metals on the dips. Chinese President Xi Jinping’s “new era” policies will be further entrenched at the March National People’s Congress with the fourteenth five-year plan for 2021-25 and Xi’s longer vision for 2035. These policies aim to guide the country through its economic transition from export-manufacturing to domestic demand. They fundamentally favor state-owned enterprises, which are an increasingly necessary tool for the state to control aggregate demand as potential GDP growth declines, while punishing large state-run commercial banks, which are required to serve quasi-fiscal functions and swallow the costs of the transition (Chart 3). Xi Jinping’s decision to promote “dual circulation,” which is fundamentally a turn away from Deng Xiaoping’s opening up and liberal reform to a more self-sufficient policy of import substitution and indigenous innovation, will clash with the Biden administration, which has already flagged China as the US’s “most serious competitor” and is simultaneously seeking to move its supply chains out of China for critical technological, defense, and health goods. Chart 3Xi Jinping Leans On The Banks To Save The SOEs Xi Jinping Leans On The Banks To Save The SOEs Xi Jinping Leans On The Banks To Save The SOEs Chinese political and geopolitical risks are almost entirely priced out of the market, according to our GeoRisk Indicator, leaving Chinese equities exposed to further downside (Chart 4). Hong Kong equities have traded in line with GeoRisk Indicator for China, which suggests that they also have downside as the market prices in a rising risk premium due to the US’s attempt to galvanize its allies in a great circumvention of China’s economy in the name of democracy versus autocracy. Chart 4China/HK Political Risk Priced Out Of Market China/HK Political Risk Priced Out Of Market China/HK Political Risk Priced Out Of Market China has hinted that it will curtail rare earth element exports to the US if the US goes forward with a technological blockade. Biden’s approach, however, is more defensive rather than offensive – focusing on building up domestic and allied semiconductor and supply chain capacity rather than de-sourcing China. President Trump’s restrictions can be rolled back for US designed or manufactured tech goods that are outdated or strictly commercial. Biden will draw the line against American parts going into the People’s Liberation Army. Biden has a chance in March to ease the Commerce Department’s rules implementing Trump’s strictures on Chinese software apps in US markets as a gesture of engagement. Supply constraints and shortages cannot be solved quickly in either semiconductors or rare earths. But both China and the US can circumvent export controls by importing through third parties. The problem for China is that it is easier for the US to start pulling rare earths from the ground than it is for China to make a great leap forward in semiconductor production. Given the US’s reawakening to the need for a domestic industrial policy, strategic public investments, and secure supply chains, we are reinitiating our long rare earth trade, using the BCA rare earth basket, which features producers based outside of China (Chart 5). The renminbi is starting to rolling over, having reached near to the ceiling that it touched in 2017 after Trump’s arrival. There are various factors that drive the currency and there are good macro reasons for the currency to have appreciated in 2016-17 and 2020-21 due to strong government fiscal and monetary reflation. Nevertheless the People’s Bank allowed the currency to appreciate extensively at the beginning of both Trump’s and Biden’s terms and the currency’s momentum is slowing as it nears the 2017 ceiling. We are reluctant to believe the renminbi will go higher as China will not want to overtighten domestic policy but will want to build some leverage against Biden for the forthcoming strategic and economic dialogues. For mainland-dedicated investors we recommend holding Chinese bonds but for international investors we would highlight the likelihood that the renminbi has peaked and geopolitical risk will escalate. There is no substantial change on geopolitical risk in the Taiwan Strait since we wrote about it recently. A full-scale war is a low-probability risk. Much more likely is a diplomatic crisis – a showdown between the US and China over Taiwan’s ability to export tech to the mainland and the level of American support for Taiwan – and potentially a testing of Biden’s will on the cybersecurity, economic security, or maritime security of Taiwan. While it would make sense to stay long emerging markets excluding Taiwan, there is not an attractive profile for staying long emerging markets excluding all of Greater China. Therefore investors who are forced to choose should overweight China relative to Taiwan (Chart 6). Chart 5Rare Earth Miners Outside China Can Go Higher Rare Earth Miners Outside China Can Go Higher Rare Earth Miners Outside China Can Go Higher Market forces have only begun to register the fact that Taiwan is the epicenter of geopolitical risk in the twenty-first century. The bottleneck for semiconductors and Taiwan’s role as middleman in the trade war have supported Taiwanese stocks. It will take a long time for China, the US, and Europe to develop alternative suppliers for chips. But geopolitical pressures will occasionally spike and when they do Taiwanese equities will plunge (Chart 7). Chart 6EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk South Korean geopolitical risk is also beneath the radar, though stocks have corrected recently and emerging market investors should generally favor Korea, especially over Taiwan. The first risk to Korea is that the US will apply more pressure on Seoul to join allied supply chains and exclude shipments of sensitive goods to China. The second risk is that North Korea – which Biden is deliberately ignoring in his opening speeches – will demand America’s attention through a new series of provocations that will have to be rebuked with credible threats of military force. Chart 7Markets Starting To Price Taiwan Strait Geopolitical Risk Markets Starting To Price Taiwan Strait Geopolitical Risk Markets Starting To Price Taiwan Strait Geopolitical Risk Chart 8South Korea Favored In EM But Still Faces Risks Over Chips, The North South Korea Favored In EM But Still Faces Risks Over Chips, The North South Korea Favored In EM But Still Faces Risks Over Chips, The North   Chart 9Don't Worry About Japan's Revolving Door Don't Worry About Japan's Revolving Door Don't Worry About Japan's Revolving Door The North Korean risk is usually very fleeting for financial markets. The tech risk is more serious but the Biden administration is not seeking to force South Korea to stop trading with China, at least not yet. The US would need to launch a robust, multi-year diplomatic effort to strong-arm its allies and partners into enforcing a chip and tech ban on China. Such an effort would generate a lot of light and heat – shuttle diplomacy, leaks to the press, and public disagreements and posturing. Until this starts to occur, US export controls will be a concern but not an existential threat to South Korea (Chart 8). Japan is the geopolitical winner in Asia Pacific. Japan is militarily secure, has a mutual defense treaty with the US, and stands to benefit from the recovery in global trade and growth. Japan is a beneficiary of a US-driven tech shift away from excess dependency on China and is heavily invested in Southeast Asia, which stands to pick up manufacturing share. Higher bond yields and inflation expectations will detract from growth stocks more than value stocks, and value stocks have a larger market-cap weight in European and Japanese equity markets. Japanese politics are not a significant risk despite a looming election. While Prime Minister Yoshihide Suga is unpopular and likely to revive the long tradition of a “revolving door” of short-lived prime ministers, and while the Liberal Democratic Party will lose the super-majorities it held under Shinzo Abe, nevertheless the party remains dominant and the national policy consensus is behind Abe’s platform of pro-growth reforms, coordinated dovish monetary and fiscal policy, and greater openness to trade and immigration (Chart 9). Favor EU And UK Over Russia And Eastern Europe Russian geopolitical risk appears to be rolling over according to our indicator but we disagree with the market’s assessment and expect it to escalate again soon (Chart 10). Not only will Russian social unrest continue to escalate but also the Biden administration will put greater pressure on Russia that will keep foreign investors wary. Chart 10Russia Geopolitical Risk Will Not Roll Over Russia Geopolitical Risk Will Not Roll Over Russia Geopolitical Risk Will Not Roll Over While geopolitics thus poses a risk to Russian equities – which are fairly well correlated (inversely) with our GeoRisk indicator – nevertheless they are already cheap and stand to benefit from the rise in global commodity prices and liquidity. Russia is also easing fiscal policy to try to quiet domestic unrest. The pound and the euro today are higher against the ruble than at any time since the invasion of Ukraine. It is possible that Russia will opt for outward aggressiveness amidst domestic discontent, a weak and relapsing approval rating for Vladimir Putin and his government, and the Biden administration’s avowed intention to prioritize democracy promotion, including in Ukraine and Belarus (Chart 11). The ruble will fall on US punitive actions but ultimately there is limited downside, at least as long as the commodity upcycle continues. Chart 11Ruble Can Fall But Probably Not Far Ruble Can Fall But Probably Not Far Ruble Can Fall But Probably Not Far Biden stated in his second major foreign policy speech, “we will not hesitate to raise the cost on Russia.” There are two areas where the Biden administration could surprise financial markets: pipelines and Russian bonds. Biden could suddenly adopt a hard line on the Nordstream 2 pipeline between Russia and Germany, preventing it from completion. This would require Biden to ask the Germans to put their money where their mouths are when it comes to trans-Atlantic solidarity. Biden is keen to restore relations with Germany, and is halting the withdrawal of US troops from there, but pressuring Germany on Russia is possible given that it lies in the US interest and Biden has vowed to push back against Russia’s aggressive regional actions and interference in American affairs. The US imposed sanctions on Russian “Eurobonds” under the Chemical and Biological Weapons Control and Warfare Elimination Act of 1991 (CBW Act) in the wake of Russia’s poisoning of secret agent Sergei Skripal in the UK in 2018. Non-ruble bank loans and non-ruble-denominated Russian bonds in primary markets were penalized, which at the time accounted for about 23% of Russian sovereign bonds. This left ruble-denominated sovereign bonds to be sold along with non-ruble bonds in secondary markets. The Biden administration views Russia’s poisoning of opposition leader Alexei Navalny as a similar infraction and will likely retaliate. The Defending American Security from Kremlin Aggression Act is not yet law but passed through a Senate committee vote in 2019 and proposed to halt most purchases of Russian sovereign debt and broaden sanctions on energy projects and Kremlin officials. Biden is also eager to retaliate for the large SolarWinds hack that Russia is accused of conducting throughout 2020. Cybersecurity stocks are an obvious geopolitical trade in contemporary times. Authoritarian nations have benefited from the use of cyber attacks, disinformation, and other asymmetric warfare tactics. The US has shown that it does not have the appetite to fight small wars, like over Ukraine or the South China Sea, whereas the US remains untested on the question of major wars. This incentivize incremental aggression and actions with plausible deniability like cyber. Therefore the huge run-up in cyber stocks is well-supported and will continue. The world’s growing dependency on technology during the pandemic lockdowns heightened the need for cybersecurity measures but the COVID winners are giving way to COVID losers as the pandemic subsides and normal economic activity resumes. Traditional defense stocks stand to benefit relative to cyber stocks as the secular trend of struggle among the Great Powers continues (Chart 12). Specifically a new cycle of territorial competition will revive military tensions as commodity prices rise. Chart 12Back To Work' Trade: Long Defense Versus Cyber Back To Work' Trade: Long Defense Versus Cyber Back To Work' Trade: Long Defense Versus Cyber By contrast with Russia, western Europe is a prime beneficiary of the current environment. Like Japan, Europe is an industrial, trade-surplus economy that benefits from global trade and growth. It benefits as the geopolitical middleman between the US and its rivals, China and Russia, especially as long as the Biden administration pursues consultation and multilateralism and hesitates to force the Europeans into confrontational postures against these powers. Chart 13Political Risk Still Subsiding In Continental Europe Political Risk Still Subsiding In Continental Europe Political Risk Still Subsiding In Continental Europe Meanwhile Russia and especially China need to court Europe now that the Biden administration is using diplomacy to try to galvanize a western bloc. China looks to substitute European goods for American goods and open up its market to European investors to reduce European complaints of protectionism. European domestic politics will become more interesting over the coming year, with German and French elections, but the risks are low. The rise of a centrist coalition in Italy under Mario Draghi highlights how overstated European political risk really is. In the Netherlands, Mark Rutte’s center-right party is expected to remain in power in March elections based on opinion polling, despite serious corruption scandals and COVID blowback. In Germany, Angela Merkel’s center-right party is also favored, and yet an upset would energize financial markets because it would result in a more fiscally accommodative and pro-EU policy (Chart 13). The takeaway is that there is limit to how far emerging European countries can outperform developed Europe, given the immediate geopolitical risk emanating from Russia that can spill over into eastern Europe (Chart 14). Developed European stocks are at peak levels, comparable to the period of Ukraine’s election, but Ukraine is about to heat up again as a battleground between Russia and the West, as will other peripheral states. Chart 14Favor DM Europe Over EM Europe Favor DM Europe Over EM Europe Favor DM Europe Over EM Europe Chart 15GBP: Watch For Scottish Risk Revival In May GBP: Watch For Scottish Risk Revival In May GBP: Watch For Scottish Risk Revival In May Finally, in the UK, the pound continues to surge in the wake of the settlement of a post-Brexit trade deal, notwithstanding lingering disagreements over vaccines, financial services, and other technicalities. British equities are a value play that can make up lost ground from the tumultuous Brexit years. There is potentially one more episode of instability, however, arising from the unfinished business in Scotland, where the Scottish National Party wants to convert any victory in parliamentary elections in May into a second push for a referendum on national independence. At the moment public opinion polls suggest that Prime Minister Boris Johnson’s achievement of an EU trade deal has taken the wind out of the sails of the independence movement but only the election will tell whether this political risk will continue to fall in the near term (Chart 15). Hence the pound’s rally could be curtailed in the near term but unless Scottish opinion changes direction the pound and UK domestic-oriented stocks will perform well. Short EM Strongmen Throughout the emerging world the rise of the “Misery Index” – unemployment combined with inflation – poses a persistent danger of social and political instability that will rise, not fall, in the coming years. The aftermath of the COVID crisis will be rocky once stimulus measures wane. South Africa, Turkey, and Brazil look the worst on these measures but India and Russia are also vulnerable (Chart 16). Brazilian geopolitical risk under the turbulent administration of President Jair Bolsonaro has returned to the 2015-16 peaks witnessed during the impeachment of President Dilma Rousseff amid the harsh recession of the middle of the last decade. Brazilian equities are nearing a triple bottom, which could present a buying opportunity but not before the current political crisis over fiscal policy exacts a toll on the currency and stock market (Chart 17). Chart 16EM Political Risk Will Bring Bad Surprises EM Political Risk Will Bring Bad Surprises EM Political Risk Will Bring Bad Surprises Chart 17Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Bolsonaro’s signature pension reform was an unpopular measure whose benefits were devastated by the pandemic. The return to fiscal largesse in the face of the crisis boosted Bolsonaro’s support and convinced him to abandon the pretense of austere reformer in favor of traditional Brazilian fiscal populist as the 2022 election approaches. His attempt to violate the country’s fiscal rule – a constitutional provision passed in December 2016 that imposes a 20-year cap on public spending growth – that limits budget deficits is precipitating a shakeup within the ruling coalition. Our Emerging Market Strategists believe the Central Bank of Brazil will hike interest rates to offset the inflationary impact of breaking the fiscal cap but that the hikes will likely fall short, prompting a bond selloff and renewed fears of a public debt crisis. The country’s political crisis will escalate in the lead up to elections, not unlike what occurred in the US, raising the odds of other negative political surprises. Chart 18Reinitiate Long Mexico / Short Brazil Reinitiate Long Mexico / Short Brazil Reinitiate Long Mexico / Short Brazil While Latin America as a whole is a shambles, the global cyclical upturn and shift in American policy creates investment opportunities – particularly for Mexico, at least within the region. Investors should continue to prefer Mexican equities over Brazilian given Mexico’s fundamentally more stable economic policy backdrop and its proximity to the American economy, which will be supercharged with stimulus and eager to find ways to use its new trade deal with Mexico to diversify its manufacturing suppliers away from China (Chart 18). In addition to Brazil, Turkey and the Philippines are also markets where “strongman leaders” and populism have undercut economic orthodoxy and currency stability. A basket of emerging market currencies that excludes these three witnessed a major bottom in 2014-16, when Turkish and Brazilian political instability erupted and when President Rodrigo Duterte stormed the stage in the Philippines. These three currencies look to continue underperforming given that political dynamics will worsen ahead of elections in 2022 (possibly 2023 for Turkey) (Chart 19). Chart 19Keep Shorting The Strongmen Keep Shorting The Strongmen Keep Shorting The Strongmen Investment Takeaways We closed out some “risk-on” trades at the end of January – admittedly too soon – and since then have hedged our pro-cyclical strategic portfolio with safe-haven assets, while continuing to add risk-on trades where appropriate. The Biden administration still faces one or more major foreign policy tests that can prove disruptive, particularly to Taiwanese, Chinese, Russian, and Saudi stocks. Biden’s foreign policy doctrine will be established in the crucible of experience but his preferences are known to favor diplomacy, democracy over autocracy, and to pursue alliances as a means of diversifying supply chains away from China. We will therefore look favorably upon the members of the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) and recommend investors reinitiate the long CPTPP equities basket. These countries, which include emerging markets with decent governance as well as Japan, Australia, New Zealand, and Canada all stand to benefit from the global upswing and US foreign policy (Chart 20). Chart 20Reinitiate Long Trans-Pacific Partnership Reinitiate Long Trans-Pacific Partnership Reinitiate Long Trans-Pacific Partnership Chart 21Reinitiate Long Global Value Over Growth Reinitiate Long Global Value Over Growth Reinitiate Long Global Value Over Growth The Biden administration will likely try to rejoin the CPTPP but even if it fails to do so it will privilege relations with these countries as it strives to counter China and Russia. The UK, South Korea, Thailand and others could join the CPTPP over time – though an attempt to recruit Taiwan would exacerbate the geopolitical risks highlighted above centered on Taiwan. The dollar is perking up, adding a near-term headwind to global equities, but the cyclical trend for the dollar is still down due to extreme monetary and fiscal dovishness. Tactically, go long Mexican equities over Brazilian equities. From a strategic point of view we still favor value stocks over growth stocks and recommend investors reinitiate this global trade (Chart 21). Strategically, wait to overweight UK stocks in a global portfolio until the result of the May local elections is known and the risk of Scottish independence can be reassessed. Strategically, favor developed Europe over emerging Europe stocks as a result of Russian geopolitical risks that are set to escalate. Strategically go long global defense stocks versus cyber security stocks as a geopolitical “back to work” trade for a time when economic activity resumes and resource-oriented territorial, kinetic, military risks reawaken. Strategically, favor EM currencies other than Brazil, Turkey, and the Philippines to minimize exposure to economic populism, poor macro fundamentals, and election risk. Strategically, go long the BCA Rare Earths Basket to capture persistent US-China tensions under Biden and the search for alternatives to China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   We Read (And Liked) … Supply-Side Structural Reform Supply-Side Structural Reform, a compilation of Chinese economic and policy research, discusses several aspects of Chinese economic reform as it is practiced under the Xi Jinping administration, spanning the meaning and importance of supply-side structural reform in China as well as five major tasks.1 The book consists of contributions by Chinese scholars, financial analysts, and opinion makers in 2015, so we have learned a lot since it was published, even as it sheds light on Beijing’s interpretation of reform. 2015 was a year of financial turmoil that saw a dramatic setback for China’s 2013 liberal reform blueprint. It also saw the launch of a new round of reforms under the thirteenth Five Year Plan (2016-20), which aimed to push China further down the transition from export-manufacturing to domestic and consumer-led growth. Beijing’s renewed reform push in 2017, which included a now infamous “deleveraging campaign,” ultimately led to a global slowdown in 2018-19 that was fatefully exacerbated by the trade war with the United States – only to be eclipsed by the COVID-19 pandemic in 2020. Built on fundamental economic theory and the social background of China, the book’s authors examine the impact of supply-side reform on the Chinese financial sector, industrial sector, and macroeconomic development. The comprehensive analysis covers short-term, mid-term and long-term effects. From the perspective of economic theory, there is consensus that China's supply-side structural reform framework did not forsake government support for the demand side of the economy, nor was it synonymous with traditional, liberal supply-side economics in the Western world. In contrast to Say’s Law, Reaganomics, and the UK’s Thatcherite privatization reforms, China's supply-side reform was concentrated on five tasks specific to its contemporary situation: cutting excessive industrial capacity, de-stocking, deleveraging, cutting corporate costs, and improving various structural “weaknesses.” The motives behind the new framework were to enhance the mobility and efficiency of productive factors, eliminate excess capacity, and balance effective supply with effective demand. Basically, if China cannot improve efficiencies, capital will be misallocated, corporations will operate at a loss, and the economy’s potential will worsen over the long run. The debt buildup will accelerate and productivity will suffer. Regarding implementation, the book sets forth several related policies, including deepening the reform of land use and the household registration (hukou) system, and accelerating urbanization, which are effective measures to increase the liquidity of productive factors. Others promote the transformation from a factor-driven economy to efficiency and innovation-driven economy, including improving the property rights system, transferring corporate and local government debt to the central government, and encouraging investment in human capital and in technological innovation. The book also analyzes and predicts the potential costs of reform on the economy in the short and long term. In the short run, authors generally anticipated that deleveraging and cutting excessive industrial capacity would put more pressure on the government’s fiscal budget. The rise in the unemployment rate, cases of bankruptcy, and the negative sentiment of investors would slow China’s economic growth. In the medium and long run, this structural reform was seen as necessary for a sustainable medium-speed economic growth, leading to more positive expectations for households and corporates. The improved efficiency in capital allocation would provide investors with more confidence in the Chinese economy and asset market. Authors argued that overall credit risk was still controllable in near-term, as the corresponding policies such as tax reduction and urbanization would boost private investment and consumption in the short run. These policies increased demand in the labor market and created working positions to counteract adverse impacts. Employment in industries where excessive capacity was most severe only accounted for about 3% of total urban employment in 2013. Regarding the rise in credit risk during de-capacity, the asset quality of banks had improved since the 1990s and the level of bad debt was said to be within a controllable range, given government support. Moreover, in the long run, the merger and reorganization of enterprises would increase the efficient supply and have a positive effect on economic innovation-driven transformation. We know from experience that much of the optimism about reform would confront harsh realities in the 2016-21 period. The reforms proceeded in a halting fashion as the US trade war interrupted their implementation, prompting the government to resort to traditional stimulus measures in mid-2018, only to be followed by another massive fiscal-and-credit splurge in 2020 in the face of the pandemic. Yet investors could be surprised to find that the Politburo meeting on April 17, 2020 proclaimed that China would continue to focus on supply-side structural reform even amid efforts to normalize the economy and maintain epidemic prevention and control. Leaders also pledged to maintain the supply-side reform while emphasizing demand-side management during annual Central Economic Work Conference in December 2020. In other words, Xi administration’s policy preferences remain set, and compromises forced by exogenous events will soon give way to renewed reform initiatives. This is a risk to the global reflation trade in 2021-22. There has not been a total abandonment of supply-side reform. The main idea of demand-side reform – shifts in the way China’s government stimulates the economy – is to fully tap the potential of the domestic market and call for an expansion of consumption and effective investment. Combined with the new concept of “dual circulation,” which emphasizes domestic production and supply chains (effectively import substitution), the current demand-side reforms fall in line with the supply-side goal of building a more independent and controllable supply chain and produce higher technology products. These combined efforts will provide “New China” sectors with more policy support, less regulatory constraint, and lead to better economic and financial market performance. Despite the fluctuations in domestic growth and the pressure from external demand, China will maintain the focus on reform in its long-term planning. The fundamental motivation is to enhance efficiency and innovation that is essential for China’s productivity and competitiveness in the future. Thus, investors should not become complacent over the vast wave of fiscal and credit stimulus that is peaking today as we go to press. Instead they should recognize that China’s leaders are committed to restructuring. This means that the economic upside of stimulus has a cap on it– a cap that will eventually be put in place by policymakers, if not by China’s lower capacity for debt itself. It would be a colossal policy mistake for China to overtighten monetary and fiscal policy in 2021 but any government attempts to tighten, the financial market will become vulnerable. A final thought: it is unclear whether there is potential for an improvement in China’s foreign relations contained in this conclusion. What the western world is demanding is for China to rebalance its economy, open up its markets, cut back on the pace of technological acquisition, reduce government subsidies for state-owned companies, and conform better to US and EU trade rules. There is zero chance that China will provide all of these things. But its own reform program calls for greater intellectual property protections, greater competition in non-strategic sectors (which the US and EU should be able to access under recent trade deals), and targeted stimulus for sustainable energy, where the US and EU see trade and investment opportunities. Thus there is a basis for an improvement in cooperation. What remains to be seen is how protectionist dual circulation will be in practice and how aggressively the US will pursue international enforcement of technological restrictions on China under the Biden administration. Jingnan Liu Research Associate JingnanL@bcaresearch.com Footnotes 1 Yifu L, et al. Supply-Side Structural Reform (Beijing: Democracy & Construction Publishing House, 2016). 351 pages. Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Since July 2020, the KOSPI index has been among the best performing equity markets worldwide (Chart 1). Will this rally and outperformance continue? The rally in the KOSPI has been due to two factors: (1) improving global growth in general and surging demand for semiconductors in particular; and (2) unprecedented domestic retail investor buying of stocks. We explore both these factors in detail below. Global Growth Tailwinds The global economic recovery will continue. With the US about to adopt another round of massive fiscal stimulus and Chinese policymakers’ cautious approach to tightening, global trade will remain robust for now. Chinese purchases account for 24% of Korean exports, the US for 17% and the EU for 10%. Importantly, due to substantial fiscal transfers to households, US demand for consumer goods will remain extremely strong, benefiting Korean exporters as a result. DRAM semiconductor prices and producers’ revenues are rising and are pointing towards more upside in share prices of their producers - Samsung and Hynix (Chart 2). Chart 1The KOSPI: Absolute And Relative Performance Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 2Rising DRAM Prices Are Bullish For Korean Semi Stocks Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making   In a nutshell, the well-publicized semiconductor shortages in the global auto industry suggests that producers’ forward order books are full. Retail Investor Euphoria Chart 3Retail Investors Drove The Rally In Korean Stocks In The Past Year Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Apart from the apparent global recovery, another major force that has been propelling Korean share prices is individual investors’ rush to buy stocks (Chart 3). Notably, retail investors bought stocks last March when foreign and domestic institutional investors were offloading their holdings. In a nutshell, were it not for local individual investors’ providing a bid for equities during the crash last March, the KOSPI index would have plummeted much more than it ultimately did. This is true for almost all bourses worldwide. Are retail investors about to withdraw from the stock market? If yes, does it mark the end of this stock market rally? There are several measures that point to built-up excesses in the equity market in general and retail investor participation in particular. Since last March, margin loans have surged 3.5-fold in absolute terms and have risen from 0.7% to 1.2% of broad equity market cap with the latter expanding tremendously (Chart 4). Consistent with the retail equity frenzy, trading volumes on the stock exchange have surged 1.5-fold (Chart 5). Chart 4Korea: Surging Margin Loans For Equity Purchases Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 5Skyrocketing Stock Trading Volume Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making   Korea’s broad equity market capitalization has reached an all-time high relative to both nominal GDP, broad money supply and household deposits (Chart 6). Overall, Korean equity prices have been driven by retail investor speculation that has created considerable excesses in the stock market. However, we cannot rule out the odds that this rally will persist and a genuine equity bubble will form. It will eventually burst, but it might get bigger beforehand. The main reason to expect the retail equity mania to last longer is the massive quantity of retail investors’ cash at brokerage accounts, ostensibly waiting to be invested. Chart 7 denotes that individual investor account balances at brokerage houses have swelled by about 2-fold since last March and now stand at KRW 65 trillion, equal to almost 4% of market cap. Chart 6Equity Market Capitalization In Perspective Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 7Individual Investors Still Have A Lot Of Dry Powder Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making   This cash on the sidelines, along with foreign investors who have not meaningfully participated in this equity rally, holds the potential to push share prices much higher. What about Korean equity valuations? Is there a historical bubble that can serve as a roadmap? Korean equities are richly valued: the forward P/E ratio is the highest in past 22 years (Chart 8). Besides, in manias driven by retail investors, valuation is not a constraint for higher prices. Finally, Korean stocks experienced a full-fledged mania and bubble in the late 1980s alongside the Japanese equity bubble. Chart 9 displays the overlay of the current rally with the one in the late 1980s in Korea. Based on this profile, share prices could rise further. Chart 8Equity Multiples Are Elevated Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 9Korean Stocks Now And During The Late 1980s Bubble Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making   Bottom Line: Korean stocks have been in a retail-investor driven mania. Rational and fundamental analysis are rendered useless during a financial mania. Odds of an equity overshoot are considerable. The Structural Outlook Can the economy grow fast in the long run, justifying current and potentially higher equity multiples? We have several considerations on Korea’s structural outlook: The Korean manufacturing industry is extremely competitive, and it will remain a major global production hub. Consistently, export-oriented companies with comparative advantages will flourish, unless the currency appreciates considerably. Hence, precluding the won’s appreciation relative to its main competitors’ currencies is critical to the profitability of Korean exporters that make up a substantial chunk of this bourse. Although Korea’s export prices are rising in US dollar terms, they are deflating in local currency terms (Chart 10). This augments the importance of exchange rates for the profitability of exporters. In fact, the currency is presently not cheap. According to the real effective exchange rate based on unit labor costs, the won is modestly overvalued while the Japanese yen is undervalued (Chart 11). Chart 10Korean Exporters Are Experiencing Falling Prices In Local Currency Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 11The Won Is Not Cheap Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making   Regarding domestic demand, the outlook is uninspiring. The share of consumer spending has been declining precipitously while the share of government spending has been rising, albeit from a low level (Chart 12). The good news is that public debt stands at a mere 41% of GDP meaning the government can keep increasing its spending. Exports’ share of GDP remains substantial at around 40%. Finally, Korea’s potential GDP growth has been, and will continue, trending lower. Chart 13 illustrates that the working age population is forecast to shrink at an accelerated rate in the foreseeable future. This will reduce potential GDP growth from 1.7% to 1% by the end of this decade (Chart 14, bottom panel). Chart 12Structure Of Korean GDP Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 13Korea's Potential Growth Rate Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making     Chart 14Korea Has The World's Lowest Fertility Rate Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making In sum, the main constraint on Korea’s potential growth is low fertility. Chart 14 reveals Korea’s fertility at 1.1 to be the lowest in the world, along with Taiwan’s. Bottom Line: Apart from competitive export industries, the structural growth outlook for domestic demand is very poor and does not justify elevated equity multiples. In turn, the export sector’s competitiveness rests on the exchange rate. The Korean won’s large appreciation versus the currencies of its competitors will hurt exporters’ profitability or reduce their market share. In short, uninterrupted share price and currency appreciation are not sustainable in the long run. Investment Recommendations We upgraded Korean stocks to overweight relative to the EM equity benchmark on November 5, 2020 and this overweight remains intact. For absolute-return investors, odds of an overshoot in Korean stocks are considerable with retail investors’ cash on the sidelines waiting to be deployed and pent-up demand from foreign investors. Manias are not over until they are over. We are booking gains on our long-standing position in Korean local rates. We have been receiving 10-year Korean swap rates since May 2011 as a bet on weaker growth and disinflationary trends in the global economy. We now see a higher risk of inflation, especially in regard to the US. Provided US bond yields largely drive Korean yields, we are taking profits on this strategy. This position has generated a gain of 280 basis points (Chart 15). The currency could correct in the near-term if the US dollar stages a countertrend rebound but the cyclical outlook for the won is positive. The Korean won appreciates when the nation’s export prices rise and vice versa (Chart 16). Chart 15Book Profits On Korean 10-Year Swap Rate Position Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 16The Won Will Be Supported If Export Prices Continue Rising Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 17KRW Is Facing Technical Resistance Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Technically, the KRW is facing an important resistance versus the USD (Chart 17). As a part of our broader currency strategy, we have been shorting the KRW along with other EM currencies versus an equal-weighted basket of the euro, CHF and JPY. We will close this trade in the near term on any potential US dollar rebound. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Vanessa Wong Ee Shan Research Associate vanessaw@bcaresearch.com Footnotes