Stick with South Korea in 2014

Consider what would happen if the totalitarian regime in North Korea collapsed and that vastly underdeveloped country of 25 million was absorbed by South Korea, with its 50 million highly motivated and industrious citizens.

Despite the huge initial costs, South Koreans yearn for this opportunity; China’s leaders probably don’t. One reason China supports North Korea is probably the desire to keep a buffer between China and South Korea and to force the South to maintain an expensive military establishment to counter the belligerent North.

Furthermore, as shown by the merger of West and East Germany after the Berlin Wall came down in 1989, it isn’t easy to recombine two groups of people that have been separated by distinct cultures for decades. Even today, 24 years later, incomes are lower in eastern than western Germany.

Meanwhile, South Korea looks like the best of the developing countries in terms of economic growth and stability as well as investment opportunities. After the global recession of 2007-9, growth has been sluggish in the United States, the euro area, the United Kingdom, Japan and other developed lands. Meanwhile, the economies of China, South Korea and many other developing countries revived and grew much more rapidly.

This convinced many equity investors that the real action was in emerging markets, where equities rose much more than in developed countries from March 2009 until mid-2011. Once again, investors forgot that those economies are all driven by exports that are bought by developed countries, principally the United States and Europe. So if mature economies are growing slowly, rapid expansions in developing countries are unsustainable.

I say once again because this belief that developing economies could decouple from the developed ones also was prevalent at the global economic peak in 2007. Many thought that China would continue to advance rapidly, despite signs of a flagging U.S. economy. I disagreed with this analysis.

Back then, I wrote that Wall Street hoped economies such as China and India would lead global growth as U.S. housing and consumers faltered. Those economies, particularly China’s, were driven by exports, which account for about 40 percent of gross domestic product. And because most exports, directly or indirectly, are bought by U.S. consumers, volume would drop as Americans retrenched.

China’s economy could shift to being domestically driven if its middle class were big enough and inclined to spend freely. But Chinese consumers save a third of their income to cover old age, health and other costs no longer provided for by the government. The stock market bubble there attests to huge savings with few investment alternatives.

And although there are an estimated 110 million people in China’s middle and upper classes, that represents only 8 percent of the 1.4 billion population, and these elites control just 25 percent of GDP. In contrast, the U.S. middle and upper classes make up about 80 percent of our 300 million people, with incomes that equal 80 percent of GDP. I expected the U.S. recession to spread globally, even to China. It did, of course.

The 2011 financial crisis in the euro area scared equity markets globally, but equity investors still viewed emerging markets favorably because of the rapid growth they expected to continue. Also, a number of these countries had higher interest rates than in the West and Japan. This appetite, which I call zeal for yield, has been robust, and many investors went after high returns anywhere they could find them, regardless of risk.

Also, many equity investors regarded all emerging markets as largely similar. But the weakness in most emerging equity markets that began in 2011 also was probably anticipating slowing growth there while activity in developing countries was expected to pick up. Since 2010, growth in developing nations has fallen by three percent to an annual rate of 5 percent, according to the IMF. From January 2012 through October 2013, the OECD’s indexes of leading economic indicators showed an increase of 0.8 percent for the United States and 1.2 percent for the euro area, but a decline of 2.4 percent for India and Indonesia, 2.6 percent for Russia and no change for Brazil and South Africa. China fell 0.5 percent.

Furthermore, in May and June, the U.S. Federal Reserve started talking about tapering and then ending its $85 billion a month of security purchases. Investors who had rushed into emerging markets stampeded out, depressing equity markets. This was true of Brazil, Turkey and Indonesia, which have sizable current-account deficits and lack the cushion to offset the money outflows. Big commodity exporters like Brazil have also been hurt by declining commodity prices.

In their effort to curb the hot money retreat, some countries have raised interest rates, weakening their currencies and spawning inflation. This risks further depressing growth. In Brazil, for example, the central bank rate is 10 percent, inflation is running at 5.8 percent and the currency lost 12.8 percent against the dollar in 2013.

Economies with robust current-account surpluses such as Taiwan and South Korea have fared much better. And the South Korean won is one of the few emerging-market currencies to rise against the dollar. Also, inflation has been low.

Investors have flocked to South Korean stocks recently. From July through late December, $14.4 billion flowed in, reversing the $8.2 billion that left in the first six months of 2013. South Korean equities aren’t cheap, trading at 16.8 times earnings over the last 12 months, but foreigners want to invest in the country’s companies, especially in the technology, retail and automobile sectors.

As noted, the South Korean economy fits between the rich countries of Europe, the United States and Japan and the developing countries. Still, because of its heavy dependence on exports (56 percent of GDP), it resembles emerging markets in a world where export-led growth is no longer a winning game. The economy’s dominance by the chaebol conglomerates (82 percent of GDP) is also more typical of developing than mature economies.

At the same time, the low inflation rate is more characteristic of developed nations. The government’s attempt after the 1997-8 Asian crisis to spur consumer spending to reduce foreign exposure caused household debt to explode, and it is now a troubling 135 percent of disposable personal income.

The low household saving rate, low fertility rate and aging population limit long-term growth unless productivity growth leaps or a reunion with North Korea unleashes a new wave of development.

Chronic government surpluses and low debt are advantages for South Korea, however. So, too, are huge foreign exchange reserves built up from years of current-account surpluses. It ranks 34th out of 177 countries for economic freedom. Other pluses include the highly educated workforce, a robust work ethic and solid banks.

That is why South Korea should be near the top of the list for investors interested in developing/semi-developed country markets.

*The author is a Bloomberg View columnist and president of A. Gary Shilling & Co. He is the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” This is the third in a three-part series.

by Gary Shilling