Are sanctions really impacting the Russian economy?

 

Since Russia's gradual invasion of Ukraine starting February 2022, governments globally have imposed numerous sanctions to punish the Putin administration. Western nations placed asset freezes on Russian foreign exchange (FX) reserves which have confiscated almost half of Russia's USD 640 billion in FX and gold reserves held overseas. Russia defaulted on its overseas debt in June as sanctions have cut off the country from the global financial system. Additionally, the Russian government cannot raise financing through overseas debt issuance. 

The following sanctions were announced by sector:

Banks: The US, UK, Canada and EU have cut certain Russian banks out of the SWIFT international payments system. This will preclude those banks from making cross-border payments. Major Russian banks can no longer undertake transactions with US institutions and individuals and several have also seen asset freezes.

Airlines: Russian airlines have been banned from UK and EU (among other countries) air spaces. Russia's largest airline Aeroflot canceled several overseas flights due to sanctions. 

Energy: The US banned Russian oil company Gazprom, pipeline company Transneft, power company RusHydro as well as the largest railway, freight and telecom companies from raising debt in its local market. The UK will terminate all oil imports from Russia by the end of 2022. 

Despite the severity of these sanctions, incoming economic data suggests that the Russian economy is coping better than expected. 

The economy is holding on better than expected:

Russia's GDP has fallen 6.3% between Q4 2021 and Q2 2022 compared to -2.8% between Q3 2014 and Q2 2015 when it annexed Crimea. However, capital investment, one of the key economic drivers rose 7.8% y/y in H1-2022, led by strong manufacturing and mining activity. 

Source: Federal State Statistics 

Note: Click on the picture to zoom in 

Industrial production has held on better than during the COVID shock as well as Crimea annexation.

Source: Federal State Statistics 

The unemployment rate is at a historical low despite sanctions. However, this may be a reflection of the exodus of working age population from the country since the beginning of the war this year.

Source: Federal State Statistics 

The Ruble is definitely not in a rubble. In fact it is one of the best performing currencies in the world this year!

Following Russia's shock invasion of Ukraine in February and strict sanctions from Western nations, the Ruble depreciated ~14% against the USD. However, this depreciation was short lived given that Russia is a major exporter of oil and gas and both these commodities are benefiting from massive price rallies this year. 

The Ruble's depreciation has been much milder than its 42% collapse between Q3 2014 and Q1 2015. 

Russia's current account balance has been booming this year given oil and gas prices. Russia is the largest exporter of gas and the second largest exporter of crude oil globally. 

The Russian government estimates oil revenue to increase towards USD 337 billion in 2022, + 38% over 2021.

While several Western nations have cut back on Russian oil imports, Russia has inked deals with Brazil, China, India and South Africa, which helped the country earn USD 45 billion trade revenue in Q1 20222 through oil and fertilizer exports. 

Following the imposition of sanctions and the reactive collapse in the Ruble, the central bank of Russia (CBR) raised the policy rate to 20% to protect the currency. Policymakers implemented China-style capital control measures to prevent capital from leaving the country. Additionally, Russia is transacting in Rubles with other nations, in order to prop up the currency.  

Experience with prior sanctions has helped Russia better prepare this time around:

Several Western companies have halted their operations in Russia and McDonald's is one example. McDonald's exited Russia by selling its stores to a Siberian coal baron. These stores have now been rebranded and opened as 'Tasty and That's It'. 

Separately, Russia has been paring down its government debt over the past decades to prevent a severe financial crisis reminiscent of the 1998 sovereign debt default. 

Russia debt to GDP (%)

To put these figures into context, the World Bank defines worrisome debt to GDP at or over 77%, indicating that Russian debt is much below worrisome level.

Russian corporate debt has also been restructured to be largely local currency denominated for ease of payment.  

The Putin administration has made efforts to reduce Russia's reliance on USD financing since facing sanctions in 2014-15 during Crimea's annexation. The CBR's foreign exchange reserves have increasingly become a mix of USD (down to 16% in 2021), Chinese Yuan (CNY), Euro (EUR) and gold. 

The central bank sounded more optimistic about the economy compared to previous expectations:

Easing inflationary pressures are now allowing the CBR to loosen financial conditions and support economic growth. After raising rates to 20% in February, the CBR cut its policy rate at subsequent meetings to 8% by July. 

The central bank estimates lower GDP contraction than previously estimated, thanks to robust exports. Russia has redirected commodity exports to new markets. Gazprom raised gas sales to China by 70% y/y in the first five months of 2022. China and India overtook Germany as the largest buyers of Russian crude oil. 

New supply routes have been forged to ease import constraints. The Russia Ministry of  Industry and Trade launched a parallel import scheme to import critical goods including auto parts, electronics, household appliances and clothing among other goods without the copyright holder's permission.  

Businesses have also prudently utilized inventory in order not to exhaust inputs. 

Russia's manufacturing purchasing managers' index (indicating month on month change in the sector's output) has been in expansion territory since May after activity collapsed in March and April. Strong demand conditions are driving higher new orders. Manufacturing activity continues to be weakened by sanctions but conditions are improving. 

Russian monthly manufacturing PMI:

Source: Trading Economics, above 50 (highlighted) indicates expanding activity 

The IMF revised down its estimate of Russian GDP contraction from 8.5% to 6% in 2022.

Towards a structural transformation in Russia:

The CBR's July statement noted the need for structural economic transformation several times. Examples include:

 "Our monetary policy takes into account the need for a structural transformation of the economy"

"The transformation of the economy will be evident from changes in the labour market. We consider this to be a key indicator of the transformation process."

"As the structural transformation progresses, we will observe an increase in the transfer of manpower between companies and sectors."

By structural transformation, the central bank is referring to the need for different sectors inter-linked with external demand to either localize production lines or completely change the range of goods they currently offer. Companies that exported goods to Europe will need to seek other markets. Other sectors will open up for import substitution and boost job creation including in the technology, aviation and space sectors. 

Europe banned the export of cutting edge technology which provides Russia the opportunity to build local expertise in quantum computing, advanced semiconductors, high-end electronics and software. 

Several media articles are now reporting new entrepreneurial ventures being established in the domestic food, cosmetics, clothing, tourism and construction industries already. 

These are mere examples and theoretical ideas of economic opportunities and implementation is key to achieving structural transformation. However, there are plenty of examples where countries gathered sectoral expertise under pressure. China is steadily building local expertise in semiconductor manufacturing given tensions with the US. Israel has built immense military and technological capability in part due to pressures from the external environment in the Middle East. Therefore, good outcomes are possible, if the government and industry take opportunities seriously.   

Sources:

https://www.nytimes.com/2022/02/03/world/europe/putin-sanctions-proofing.html

https://internationalbanker.com/finance/we-are-witnessing-a-global-de-dollarisation-spree/

 https://www.cbr.ru/eng/press/event/?id=14034

PS: I have published a course on applying macroeconomics to the equity market where I teach novice and experienced investors how to use simple and easily accessible macroeconomic data to invest in the equity market. Please find a free video lesson uploaded here.

I encourage you to begin the course if you are interested in the topic!

What history teaches us about recessions in the US

The US Q2 GDP data released last week signals a technical recession in the world's largest economy. GDP shrank 0.9% Q/Q following last quarter's 1.6% contraction. Weak housing investment on the back of the Fed's aggressive rate hikes and easing consumer demand drove the contraction. 

With supply chain bottlenecks persisting and the war in Ukraine keeping energy prices elevated, it seems unlikely that this growth slowdown stops anytime soon. Case in point is the Eurozone where manufacturing purchasing managers' index (PMI) fell into contraction territory in July for the first time since June 2020 due to easing global demand. Consumer confidence is at a record low and consumers are cutting back on spending amid broad based inflation.  

We can think about the upcoming recession by taking cues from previous episodes of high inflation, supply chain bottlenecks and subsequent hit to consumer demand.  

The 1973-75 oil price shock and early 1990s gulf war are good examples of similar economic conditions.  

1973-75 oil shock: Arabic oil producers imposed an oil embargo against (primarily) Western economies for supporting Israel in the Yom Kippur War. The lack of oil imports and production cuts imposed by the Organization of Arab Petroleum Exporting Countries (OPAEC) drove a 300% rally in the price of oil between October 1973 and March 1974. 

Severe oil shortage raised US CPI towards 12% by 1974 and 14% by 1980 leading Fed chair Paul Volcker to raise rates towards a record high 20% in the early 1980s!

During this shock, US GDP contracted in 5 quarters (on a quarter-on-quarter basis) and it took 10 quarters for GDP to revert to pre-recession period. 

By gross value added, capital markets (-37%), chemicals (-20%), automotives (-11%) and natural resources (-10.3%) were the worst affected sectors.  

The unemployment rate rose from 4.6% in October 1973 to 9% in May 1975.

Employment contraction was the sharpest in construction (-9%), automotive manufacturing (-4%), chemicals for non-durable goods (-6%) and aerospace and defence (-3.4%) sectors. 

During the 70s, the global economy was facing crop failures, strong consumer demand and cuts to oil supply, quite similar to the current scenario. The challenge with supply-side shocks is that there is very little the central bank can do to control prices aside from controlling demand through interest rate hikes. The Fed chose to implement the latter in the early 80s, plunging the US (and global economy) in a recession. 

Early 1990s gulf war: Iraq's invasion of Kuwait resulted in lower oil production in the two oil producing economies and a rally in oil prices. Crude oil rose from USD 18 per barrel pre crisis towards USD 40 at its peak. 

US GDP contracted in 2 quarters and it took 6 quarters for GDP to reach to pre-crisis level. US CPI inflation rose towards 6-7% in 1991. The airlines sector was hard hit given rising oil prices as well as a decline in travel spending. 

By GVA, automotive (-23%) and energy (-11%) sectors were hard hit. By employment, industrial (-10%), aerospace and defense (7%) and automotive (-5%) were adversely impacted.

These are sectors highly correlated to economic activity through government and discretionary consumer spending. 

Imagining the upcoming recession:   

In thinking about the upcoming recession, it is important to identify the potential sources of economic pressure and how these differ from previous recessions. Similar to 1973-75 and early 1990s, this recession is likely to be triggered by elevated oil prices, transport and logistical bottlenecks and financial market tightening. What differentiates the current period is the prevalence of a global pandemic which may detract from GDP through lockdowns and restrictions. 

Another differentiating factor is the relative inability of governments and central banks to shield their economies through traditional tools today. The entrenched nature of inflation in the US, Europe and Asia will prevent central banks from cutting rates. Secondly, governments globally threw the kitchen sink at the economy during COVID. This resulted in much weaker fiscal profiles post pandemic and several government institutions are currently implementing fiscal consolidation to appease the rating agencies.

Governments will need to engineer some degree of demand destruction to improve the supply-demand mismatch in all markets globally. Indeed, the aggressive pace of rate hikes by the Fed (inspired by Volcker's courageous fight against inflation) is likely to depress business investment and consumer spending in the quarters to come. 

8 simple macro concepts to understand the economy and financial market

The COVID-19 pandemic drove a boom in retail investor participation in the global equity market. Ultra-low central bank policy rates to combat the economic shock, cash handouts by governments as well as spare time at home encouraged neophytes to invest in the market for better returns. Retail investors represented 25% of total trading volume in the US in Q1 2021 compared to 11% in 2011! (Source: BNY Melon)

New and young investors can make better investment decisions by following and understanding the macroeconomic context. As an economist and investment strategist, I produced investment recommendations by taking cues from the economic environment.

As you join the investment band wagon, here are some macroeconomic concepts that can aid you in understanding the economic context and connecting it to finance and investment.

Gross domestic product (GDP) and GDP growth: GDP refers to the sum of the final price of all goods and services produced in a country in a year. Its growth rate determines the economic momentum of a country. High GDP growth lifts the average income of the population, boosts local businesses and attracts foreign investment.

Application in finance: Economists and investment strategists use GDP data to identify growth trends in economies and formulate investment recommendations. For instance, robust consumption growth may indicate scope for good investment opportunities in fast-moving consumer goods (FMCG) companies. Strong trade (exports-imports) data should nudge you to look into major exporting companies and their products. National statistics agencies publish GDP data by industry (agriculture, mining, manufacturing and IT, among others), which is helpful to spot growing industries.

High GDP growth, if unchecked, may over heat the economy and stoke inflation (think Turkey under President Erdogan’s leadership). The central bank will need to raise the policy rate to control prices, leading to higher yields and lower returns for bond investors (inverse relationship between bond price and yield).

Infrastructure projects including toll roads, data centers and renewable energy are financed from the cash flow of the project. Higher GDP growth boosts project cash flow as greater economic activity brings more business to existing infrastructure.

Higher economic growth benefits public equities (companies listed on the stock exchange) by creating a more exuberant and optimistic environment for equity and bond investors. It is easier for listed companies to obtain financing, grow revenue through high consumer demand and invest in ambitious ventures.

Inflation: Financial market experts study two inflation indicators— consumer price and producer price inflation. Consumer price inflation (CPI) is used more broadly and reflects the year over year increase in the price of a bundle of consumption items. Producer price inflation (PPI) refers to the growth in price of raw materials and other inputs used by businesses.

Application in finance: Higher CPI inflation indicates rising consumer prices and falling purchasing power of the local currency (known as currency depreciation). Higher producer prices (current environment is a good example) lead to narrower profit margins for firms if they are unable to pass on input prices to consumers.

CPI inflation affects the stock market through various channels. Some sectors thrive while others get depressed. Please check my article on macroeconomics for equity investing to understand how inflation affects stocks.

High frequency indicators: Financial market experts often cite high frequency data to follow the pulse of the economy. High frequency indicators are published monthly and cover different aspects of the economy such as manufacturing activity, consumer spending and factory production. The most common high frequency indicators published by most advanced and emerging markets include:

Purchasing managers’ index (PMI) manufacturing and PMI services: These indices reflect the monthly activity in manufacturing and services sectors in a country. An index value above 50 indicates that the sector is growing month over month, while a value below 50 shows contracting activity. These indicators are particularly useful for heavy manufacturing countries including Singapore, South Korea and Germany as well as services-driven economies such as the US, Hong Kong and India.

Retail sales: Indicates the consumer spending momentum in a country on a monthly basis. This is an important indicator for economic growth and is used by both equity and bond market investors. Retail sales is a good indicator for countries that derive a high contribution to economic activity from consumption, including US, China, India and Indonesia among others.

Bank lending: Or credit disbursal is an indicator to determine the liquidity in an economy and consumers’ and/ or businesses’ access to bank lending. Higher credit disbursal encourages consumer spending and business investment.

Capital flow: Foreign capital flow into or outside an economy influences stock prices, economic activity and local currency. Foreign capital flow can be studied through variables such as foreign direct investment (FDI) and foreign portfolio investment (FPI). FDI refers to foreign investment into setting up factories and acquisition of local companies. FPI is foreign investment into local stocks and bonds.

During high growth periods, countries are likely to attract foreign portfolio capital into stocks and bonds, which could inflate equity prices. This occured in several emerging markets in 2021 during economic recovery from the pandemic. Foreign capital inflow raises demand for local currency and induces local currency appreciation.

Fiscal policy: Refers to the government’s expenditure on the economy and its implication on government debt and deficit.

Application in finance: Government debt and deficit impact government as well as corporate bond yields. Additionally, these fiscal variables are factored into sovereign credit ratings that affect all debt instruments in the economy. High government debt or fiscal deficit worsen a government’s fiscal profile and lead to higher bond yields as debt investors seek higher interest payments to offset the risk of default.

A weak fiscal profile limits the government’s capacity to boost GDP growth through infrastructure spending. For instance, the Indian government was unable to drastically stimulate the economy over the past few years given its weak fiscal finances.

Monetary policy: Refers to the policy rate set by a country’s central bank. The central bank rate affects the yield on all debt instruments in an economy (loans, bonds).

Application in finance: Monetary policy tightening generally detrimentally impacts the equity market as firms face a challenging environment to service their debt servicing cost. Small cap stocks are disproportionately hit as smaller firms and startups with less robust balance sheet are more vulnerable to higher rates.

Higher policy rate, ceteris paribus, raises the return for lenders in the domestic economy relative to other countries. This brings foreign capital into the domestic economy in search of higher debt returns and leads to currency appreciation.

Readers can follow simple macroeconomic concepts such as GDP growth, inflation, high frequency data and fiscal and monetary policy announcements to gauge the pulse of the economy and use these indicators to understand the financial market.

Indian house price recovery...gone in a jiffy?

• Indian house prices grew sub-5% in 2021, amidst post COVID recovery, bucking the global boom in home prices
• Government policies, banking sector deleveraging and COVID had driven a decade long slump in the sector
• The nascent recovery in demand during the pandemic may now be threatened by rising input prices, property sector deleveraging and the eventual rollback of regulatory easing

Indian real estate has bucked the global trend of booming house prices during COVID. According to the Reserve Bank of India (RBI), house prices grew sub-5% y/y in 2021, much lower than the global house price increase of 10.3% as per Knight Frank research.

Prior to COVID, India’s real estate market had been undergoing a slowdown stoked by government policy decisions and banking and property sector deleveraging. After the Delta wave subsided in H1-2021, there were nascent signs of recovery in house prices given the demand for spacious homes. However, rising input prices and regulatory rollback may halt the nascent signs of recovery.

Government policies drove a slowdown in the real estate sector since 2013:

In the first tenure of the Narendra Modi government, policy measures were introduced to clamp down on property market speculation by diminishing the tax incentives on rental homes and curbing black money transactions. In December 2016, the government shocked the country by announcing the demonetization of 500- and 1000-rupee notes in order to curb corruption, counterfeit currency and terror funding. The real estate sector took a hit as cash is an important means of financing home buying. Housing sales plummeted and stressed balance sheets drove many developers to bankruptcy.

Since 2015, India’s banking sector has been undergoing a painful deleveraging process to identify and resolve non-performing assets. This clean-up, though necessary to resolve bad debt, detrimentally impacted bank lending and hit loans towards housing and commercial real estate.

India bank loan growth (y/y)

Thereafter, in September 2018, IL&FS, a systemically important shadow finance company defaulted and triggered a chain reaction. This episode stoked severe risk aversion in the banking sector and drove a growth slowdown in the country, affecting the real estate sector as well.

India quarterly GDP growth (y/y)

As the economy started recovering from these successive shocks at the beginning of 2020, the pandemic hit. The government announced a nationwide lockdown between 25 March and 31 May, that resulted in a 24.4% decline in the GDP in calendar Q2-2020! House prices, much like the rest of the economy, took a hit during this period as activity came to a stand-still.

These successive policy actions kept house prices depressed through the last decade. Following the delta wave, home prices were recovering with the rising demand for spacious homes and salary hikes enjoyed by service sector workers.

However, input cost inflation, property sector deleveraging and the rollback of regulatory measures may keep home prices depressed.

Elevated input prices may choke the nascent demand recovery:

The delicate recovery in housing demand after the second wave of COVID may be threatened by the broad-based rise in input prices such as oil, steel, cement, bricks and sand due to global commodity shortages. Several developers in New Delhi and Mumbai are now threatening to halt construction activity as higher input prices are turning projects unviable.

Surveys conducted by Housing.com suggest that home buyers are seeking flexible payments and discounts to pull the trigger on buying a house, indicating the price sensitivity of the home buyer.

Property developers are undergoing consolidation:

India’s property developer sector has undergone a significant consolidation, amidst a weak real estate market and distrust among home buyers. Instances of incomplete or delayed property construction and foul play by indebted developers drove this buyer distrust as well as a pileup in unsold inventory over the past few years. Weak demand and stressed balance sheets led many developers to close shop and shrank the number of participants in the sector. Developers are now focusing on volume growth rather than price appreciation, to maintain cash flow and continue deleveraging.

Regulatory measures will soon be rolled back:

Amidst the dismal economic performance during COVID, the government announced regulatory measures to boost consumer sentiment and demand for housing. These included stamp duty cuts and discounted registration fee to encourage home buying. Although these measures helped spur demand at the margin, the rollback of such policies in the coming months will likely dent the propensity to consume.

These headwinds indicate that the nascent signs of recovery in the Indian housing market may be short lived.

The Fed's policy may just drive a recession

On 16 March, the US Federal Reserve (Fed) hiked its policy interest rate by 25 basis points and started the process of monetary policy tightening after slashing rates to 0% during COVID. This move along with its plans to hike at each of the subsequent six meetings this year was expected by the market. What surprised market participants was the Fed’s terminal policy rate expectation (the highest policy rate it expects out of this rate-hiking cycle) at 2.75% by 2023 versus the estimated long-run neutral rate (the rate supporting full employment while keeping inflation constant) of 2.35%. The Fed also plans to start shrinking its balance sheet earlier than expected and as soon as in May.

What prompted this degree of hawkishness? For one, US inflation at 7.9% in February is the highest since 1982! Second, the US labour market is pretty tight with the unemployment rate at 3.8% in February, close to the pre-pandemic rate. Additionally, job gains have been widespread across leisure and hospitality, professional services, healthcare and construction.

The Fed published its revised economic forecasts for 2022–24 after the policy meeting. It was striking to see the downward revision to its US growth forecast at 2.8% in 2022 compared to its December forecast of 4.0%. The significant increase in commodity prices and economic uncertainty are expected to drive this slowdown. Simultaneously, it projected personal consumption expenditure growth at 4.3% vs 2.6% in December. The epic level of policy stimulus undertaken during COVID both from the fiscal and monetary sides had driven inflation higher throughout 2021 in the US. 2022 added the extra layer of commodity price shock arising out of the Russia-Ukraine conflict.

Following the announcement, the 10Y-5Y US Treasury (UST) spread turned negative, in other words, the yield curve inverted, signaling that the market has started pricing in an economic recession. This was driven by expectations around a global growth slowdown from elevated commodity prices and the degree of monetary policy tightening projected by the most important central bank. Thanks to the 0% interest rate in the US over the last two years, corporate America issued copious amounts of debt to stay afloat. Non-financial corporate debt rose by USD 1.2 trillion during the pandemic. Corporates will now face higher interest rates and some are bound to go bankrupt in trying to meet their debt obligation. Although the Fed did not amend its unemployment forecast for 2023 (at 3.5%), I would assume job losses starting this year as corporates restructure to raise cash and service their debt.

Despite the degree of interest rate hikes forecasted, the Fed does not expect a recession. In fact, Fed chair Jerome Powell cited three historical instances in 1965, 1984 and 1994, where the Fed was successful in cooling the economy through interest rate hikes without causing a recession. The market disagrees and between you and me, the market usually pre-empts and forces the Fed’s actions.

In this stagflation scenario — with growth slowing and inflation remaining persistently high — how should an investor think about portfolio construction? Consumer staples are an obvious beneficiary as higher prices force buyers to cut back on discretionary spending. Utilities and healthcare are other defensive sectors that could protect the portfolio. Loading up on blue-chip names is another good move. You may have come across the argument that ESG investment is inflationary as it penalizes investment in fossil fuel and metals and thereby creates an uneven supply for important commodities. I would take this prompt and add green metals that are needed for renewable energy generation to my portfolio. These include lithium and cobalt (used in batteries), copper (wind, solar PV) and zinc (wind, solar, hydro, energy storage) among others.

Some regions such as Asia have relatively dovish monetary policies compared to the West as inflation is not out of control. Here, ASEAN stocks continue to benefit from their disproportionate exposure to financials, real estate, materials and construction sectors that outperform during inflation. Please check my piece on ASEAN as an inflation hedge for this topic.

Central banks globally are struggling to juggle high inflation and easing growth. At the moment, containing inflation appears to be the number one priority. However, as monetary policy tightening weakens growth, central banks may disappoint the market’s rate hike expectations in order to protect the economy. This would create a good environment for bond investments to thrive, particularly next year.

Conclusion:

The Fed’s aggressive interest rate projections coupled with elevated commodity prices suggest the rising probability of a recession in the US and global economy.

Portfolio construction during stagflation periods should tilt towards defensive sectors such as consumer staples, healthcare and utilities.

Green metals that are used in renewable energy generation and select sectors that benefit from inflation are a good fit in the current environment.

Please consider contributing to humanitarian efforts in Ukraine. Refer to this or this website for organizations undertaking humanitarian efforts.

Reforming corporate Korea out of stagnation

 

South Korea is the tenth largest economy by gross domestic product and has a per capita income of USD 31,360 (2020), qualifying it as an advanced economy. Korea was given the title of the ‘Miracle on the Han River’ for its spectacular rise from an agrarian economy in the 50s to an industrial power house in the latter half of the 20th century.

Despite its notable economic achievements, the Korean equity and currency markets are hindered by governance challenges and investment hurdles. These have kept Korea in the emerging market (EM) bucket by equity index provider MSCI since 1992. Weak corporate governance in large conglomerates, restricted access to the currency market and onerous onboarding hurdles for foreign investors among other factors, have prevented Korea’s upgrade to developed market (DM) status.

Why is corporate governance a big issue in Korea?

Korea’s benchmark Composite Stock Price Index (KOSPI) is dominated by family-run conglomerates called Chaebols (wealth clique in Korean) such as Samsung, LG, SK Hynix and Lotte among others. Chaebols constitute over 50% of the KOSPI’s market cap and the top 10 own over 27% of all business assets in the country. Chaebol families were praised for their role in industrializing Korea during the 60s and 70s and turning the nation into a manufacturing powerhouse from an agrarian economy. Today, Korea’s economy is the 10th largest in size, in a large part thanks to Chaebols.

Notwithstanding their massive contribution to the economy, Chaebols are notorious for their opaque corporate governance policies to retain power with founding family members. These conglomerates have often used circular shareholding structures, made decisions to favour family members and generally disregarded minority shareholder returns. To provide context — the gap in the dividend payout ratio of MSCI World (comprising developed market stocks) and MSCI Korea stood at 21.72 ppt in 2000, 28.01 in 2010 and 29.85 in 2020. The persistent weakness in dividend payout — as Chaebol managements prefer to hoard cash rather than invest — drive Korean stocks’ valuation discount to peer indices as well.

Activist hedge funds are trying to force policy changes

An activist hedge fund invests in companies and plays an active role in changing policies and / or management to unlock business improvement and value. Several activist funds have endeavoured to implement governance reforms in Korean corporates. Local fund KCGI attempted to remove Korean Air / Hanjin Group CEO and establish an independent board of directors to improve decision-making. Samsung’s Lee family is notorious for retaining power with family members. In 2015, activist hedge fund Elliott Management failed to prevent the merger of Samsung C&T and Cheil Industries as the Korean government intervened and backed the Chaebol. This was despite Samsung heir Lee Jae-yong’s blatant attempt to consolidate power in the corporation. These examples highlight the difficulties faced by minority shareholders to unlock value from the biggest Korean firms.

Korean stocks have stagnated over the past decade

Aside from corporate governance challenges, Korean stock prices are held back by the cyclical nature of businesses. For instance, the KOSPI is dominated by cyclical stocks such as semiconductors (Samsung, SK Hynix), shipbuilding (Hyundai), construction (Hyundai Engineering and Construction) and steel (Hyundai Steel, POSCO) that are sensitive to the economic cycle. Korea is an important producer of memory chips that go into manufacturing electronics. The memory chip sector is highly cyclical and correlated to global economic cycle and firm inventory. The KOSPI is often vulnerable to shifting sentiments of the memory chip sector. This generates earnings volatility for corporates and prevents steady flow of capital from foreign investors.

An upgrade to developed market status to the rescue?

If Korea were to achieve an upgrade from emerging to developed market (DM), its stocks would be added to the MSCI World indices which have greater capital invested in them. Against the USD 960 billion tracking MSCI EM, MSCI World Indices benefit from approximately USD 3.6 trillion in assets under management. Research houses estimate USD 20–50 billion capital inflow into Korean stocks upon inclusion into MSCI World indices. These flows may finally help the KOSPI reach the aspired 4000 level and exit the prolonged period of stagnation.

Public officials may be keen for reforms

Korea elected conservative People Power Party’s Yoon Seok-youl as its next president on 9 March. As a former high-profile prosecutor general, Yoon took corrective action against large corporations, suggesting the potential for corporate governance improvements under his leadership.

Democratic Party (DP)’s candidate Lee Jae-myung called for reforms to facilitate Korea’s upgrade to DM during his election rally. In response to MSCI’s wish list, the Korean finance minister spoke about implementing currency reforms this year. It is too early to tell, but these developments paint an optimistic picture for Korean stocks.

Conclusion

Given the stagnation in Korean stock prices and the very low expectation of an upgrade to DM (following numerous failed attempts), the realization of an upgrade and entry into MSCI World indices could be very positive for Korean stocks. From an investor’s perspective, any seriousness from policymakers and Chaebols for corporate reforms is positive. In recent years, Korea’s Fair Trade Commission (FTC) banned new circular shareholdings in 2013, facilitating a reduction in business owners holding key board posts. Companies with independent audit committees rose and the KOSPI’s dividend payout ratio has been inching higher. This momentum needs to continue to see any evident impact on share prices.

Please consider contributing towards humanitarian efforts in Ukraine. Refer to this or this website for organizations that are assisting Ukraine.

ASEAN as an inflation hedge

The epic proportion of fiscal stimulus in advanced economies, pent-up demand post COVID and supply-chain shortages had together raised inflation in the global economy since 2021. As the pandemic subsided in 2022, the expectation of many had been for raw material shortages to ebb and inflation worries to gradually subside.

Enter Russia’s invasion of Ukraine and its grave implication on the commodity market. Russia is an important exporter of crude oil, natural gas, aluminium, palladium and wheat among other commodities. As Western governments slap sanctions against Russia, commodity prices including Brent Crude have rallied. Higher commodity prices are likely to elevate inflation, particularly in net oil and commodity importing nations.

ASEAN stocks thrive during inflation:

Investors can prepare themselves for the equity-market volatility by investing in stocks and sectors that benefit from higher inflation. In an earlier post, I had identified sectors such as banks, insurance, energy and real estate, where companies see higher revenue during inflationary periods.

One way to play the inflation theme is by investing in ASEAN equities. If we take a look at the MSCI ASEAN index — financials constitute 38% of the index, followed by consumer staples at 8.31%, real estate at 8.19%, materials at 6.04% and energy at 4.49%. Over 60% of the index contains stocks that thrive during inflation!

Extracted from MSCI ASEAN Factsheet, January 2022

How certain sectors react to inflation:

• Financial stocks thrive during rising inflation as central banks hike their policy rate to manage price pressures. This increase in the policy rate allows banks to charge higher interest on their loans.
• Consumer staples are products that are essential for daily living such as food, clothing and personal products. Rising prices drive consumers to cut back on discretionary spending (on new gadgets, vehicles) and concentrate spending on essential items.
• Real estate benefits from higher rent and property investment to hedge against falling purchasing power of currency.
• The materials’ sector comprises companies producing chemicals, construction materials, containers and packaging goods and metals and mining products. You may have been reading about the rally in gold, silver, aluminium and copper among other metals since 2021, given the economic reopening, surge in demand and constrained supply in these items.

MSCI ASEAN constitutes countries rated investment grade:

By country, the MSCI ASEAN index is dominated by Singapore, a AAA rated credit (highest credit rating) by S&P, Moody’s and Fitch ratings. Thailand, Indonesia, Malaysia and Philippines, the other countries in the index, are all rated investment grade by the agencies. While ASEAN countries are mostly classified as emerging markets, consider them to be better quality EMs given their historical growth profile, government indebtedness, central bank policymaking and business environment.

The top 10 constituents of the index are all large cap stocks (where market capitalization exceeds USD 10 billion), indicating that the index benefits from quality companies that offer stability during periods of geopolitical unrest and risk-off.

ASEAN’s macro outlook is likely to improve in 2022:

Barring Singapore which profited from 7.6% y/y growth in 2021, all other ASEAN economies underperformed growth expectation set at the start of last year. This was led by the spread of the highly infectious Delta variant, low vaccination rates and intermittent imposition of movement restrictions in these nations. This suggests the scope for strong recovery in 2022, led by better vaccine coverage, milder impact of the Omicron variant and with pent-up demand being unleashed.

As per the IMF, the average growth rate of Thailand, Indonesia, Malaysia and Philippines is forecasted at 5.67% y/y in 2022 compared to 2.72% in 2021. This improvement in growth, led by consumer spending and business revival is likely to support companies and stocks. Consumer price inflation is also forecasted to maintain steadiness at 2.29% in 2022 compared to 2.3% in 2021, much higher than the 0.67% seen in 2020. Higher inflation will support the MSCI ASEAN index.

Good growth outlook, attracts foreign capital. The capital flow tracker prepared by the Institute of International Finance (IIF) corroborates this statement for the ASEAN region. The graph below shows foreign capital returning to EM ASEAN countries in late 2021.

Data extracted from The Institute of International Finance (IIF) capital flow tracker

Note: Please click on the chart to zoom in

Conclusion:

• Inflation pressures are likely to persist in 2022 given geopolitical developments and economic recovery.
• Investors should modify their portfolio by adding stocks that benefit from higher inflation.
• One solution is by investing in the MSCI ASEAN index. Over 70% of the index is composed of sectors that thrive during inflation.
• MSCI ASEAN’s country exposure is dominated by Singapore, a country rated AAA by the rating agencies. The index is exposed to quality large cap names that are likely to protect the portfolio from equity market volatility.