EQUITIES 6 minutes to read

Why South Korean equities are important for the business cycle

Peter Garnry

Head of Equity Strategy

Summary:  It is well known that South Korea is often used as an indicator of future developments in the global economy because its industrial composition simply puts it ahead of the curve. What's less often recognised is that South Korean equities play exactly the same 'canary in the coalmine' role.


Last Friday’s Equity Monthly looked at where the global economy is in terms of the business cycle and how that translates into positioning within equity sectors. Basically, the global economic activity is below trend growth and still contracting, which is the critical phase for policy makers because it is in this phase of the business cycle that the economy can slip into recession. The current business cycle phase indicates that investors should be cautious on equities and tilted towards defensive sectors such Communication Services, Healthcare, Consumer Staples but also the cyclical Information Technology sector. 

South Korea is the lighthouse to watch

Extending the analysis, we follow up with a study of equity returns related to broader equity markets against the four phases of the business cycle. Our equity market universe consists of 18 developed equity markets and six emerging markets. The table below shows the average monthly return in USD across these 24 equity markets across the four different phases of the business cycle using data from 1995-2019. As with our sector breakdown it is not surprising to average negative returns when growth is easing/contracting compared to expanding. However, diving into the numbers the natural picture of defensive and cyclical equity markets related to the business cycle becomes obvious. We will cover that shortly.

But there is one equity market that stands out completely from the rest and that is South Korea.  It is the only market that has a negative return in the above trend and expanding business cycle phase, also called the booming phase. Why is that? Well, it is a well-known fact that South Korean macro indicators are often used in global composite leading indicator models (because of its very cyclical industries such as autos and semiconductors), but this data also highlights that the South Korean equity market is ahead of everyone else. 

The negative return in the booming phase shows that South Korean equities turns lower before everyone else. Likewise, in the below trend and contracting business cycle phase, also called the recessionary phase, South Korea stands out with high positive returns where other equity markets are declining. Again South Korean equities turn before the upswing. The conclusion is that South Korean equities are very important to monitor in terms of gauging where global equities are headed next.
 
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What does South Korea tells us about global equities?

South Korean equities are still down 19.4% from the peak measured in USD but the recent 12% rebound raises the possibility that we have turned in the business cycle. Next week we will get updated figures on the OECD’s leading indicators for December and this will guide us in relation to whether the global economy is stabilising or still slowing. But for now South Korean equities are telling global investors that sentiment and growth dynamics might have turned a corner. 

The index is a key resistance level going back to around mid-October. If South Korean equities can push through that and also take out the heavy resistance level from the August-October 2018 period then it’s risk-on across the board for global equities. Until then there is significant risk of equity markets turning down again as the negative economic dynamics are still in play.

MSCI South Korea Index in USD the past five years
 
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Source: Bloomberg
Cyclical and defensive equity markets

Based on the table we can infer that the following five equity markets have done well in the past in the current business cycle environment.

1. South Korea
2. Hong Kong
3. Australia
4. Canada
5. United States

These equity markets should not be a big surprise as these are cyclical in nature and turn higher just as the current business cycle phase comes to an end. Equity markets are a leading indicator, after all.

In the following business cycle phase (upswing) when economic activity begins to expand again but is still below recent trends, the following five equity markets have done well in the past.

1. China
2. Taiwan
3. Singapore
4. United States
5. Sweden
 
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