In previous posts, I have laid out the late-cycle dynamics which could derail this global bull market, which seems to have been propelled by excess liquidity flowing from China, Japan and Europe. Markets have bounced hard off recent lows, as the S & P 500 dropped as much as -10%, and tested its 200 day moving average. There are few signs of weakness in the U.S. or global economy, which has fueled a self-perpetuating cycle of positive sentiment (see ’99 Redux ). On top of the continued excess liquidity from global central banks, the recent tax cuts passed in the U.S. will provide near term stimulus as the budget deficits, which are already the highest since 2013 at 3.4% of GDP, are set to surge higher. There has been no persistent inflationary pressures throughout this cycle, allowing central banks to provide liquidity at every sign of weakness, and to keep the spigots on at least partially during the mediocre growth that has prevailed. With labor markets starting to tighten, and inflationary pressures rising, central banks’ friendly demeanor is unlikely to remain so friendly.
The recent selloff was quite overdue, given a run that had become excessively exuberant. While possible that we have seen the highs, the strength and breadth of growth makes it just as likely that those highs will be tested (maybe bested!) after a period of consolidation. The real key will be the action in interest rates and availability of liquidity (see The Only Thing to Fear is…Higher Rates? ). So far, rates and expectations have remained extremely tame. Which is why the recent sharp correction should be somewhat concerning to investors. Rate sensitivity could be higher than in the past, because the duration of this business cycle has hinged on continued central bank liquidity.
A Global Hedge
Historically, the South Korean economy tends to be strongly cyclically linked to the global economy. That makes the currency, the Won, a pretty efficient hedge against global risk off (the Won dropped -42% in the 2008 crisis). That cyclicality alone makes it a good hedge, but present fundamentals are what make it stand out.
In a previous post, I introduced a fundamentally based indicator (F-FX) designed to project moves in currencies (see FX Dynamics Part 1: Dollar Weakness ). Chart 1 shows the Korean Won vs. the U.S. Dollar (KRWUSD) normalized, along with the F-FX indicator. In line with previous charts provided, there is a strong tendency for the currency to move in the direction of the F-FX. In April 2014, the F-FX registered a -73. In the next 2 months, the Won dropped -11% relative to the dollar over the next 9 months. Over the next year and a half, the Won depreciated around -20%.
Ideally, it is helpful to combine a fundamental view with some sort of positioning indicator. Most FX positioning takes place in the forwards market, for which there is no comprehensive positioning measure (although many investment banks track as best they can). As a proxy, I typically use CFTC futures positioning. Unfortunately, for the Won, the futures trade so little that the CFTC does not bother to track positioning. In this case, we need to rely more on economic data.
Economic Data for South Korea is Weakening
Chart 2 shows the Citi Economic Surprise Index. This index is a useful indicator to compare incoming economic data against expectations. Positive numbers show that, in general, economic data is beating expectations, while negative numbers indicate most data is missing expectations. The present level of -136 has improved a bit recently after dropping to the worst levels (and at the fastest rate) since 2008. As shocking as this may be, caveats are in order. The sharp drop came on the heels of the highest level since 2011. Key to understanding the surprise index is that it is designed to measure deviations from consensus expectations (forecasts), not levels of growth. Back in October, 2017, Korean economic data was significantly better than expectations, leading to an upgrade of future forecasts. Since then, forecasts have proven too optimistic for Korea on a level equal to 2008. This does not mean a crisis is on the way – or even necessarily a recession. However, it does mean that expectations for growth need to be downgraded. And expectations are what drive markets.
Source: Citigroup and Bloomberg
A look at some recent South Korean economic data is concerning. The last report of sequential quarterly GDP registered the first negative growth rate (4Q quarterly GDP dropped -0.2%) since 2008. On a year over year basis, Industrial Production measured a drop of -6% for the month of December, and has been running at a negative rate since September. Relative to strong global growth, this weakness stands out.
Interest Rate Differentials are Bearish
In previous posts concerning FX (see FX Dynamics Part 1: Dollar Weakness or FX Dynamics Part 2: Yen Strength ) I made no mention of interest rate differentials as driver of currency movement. Since interest rates do often have a strong relationship with FX, some might find this odd. My own research finds that correlations between interest rates and FX is quite variable. Rates may lead, lag or move coincidentally with FX. The dominant rate (duration) correlation will change as well. Sometimes 10 year rates seem to drive currency movement. At other times it may be the 2 year, or overnight rates with the highest correlation.
None of this is to say that rates cannot provide some clues on FX movement, but they need to have corroboration from other data. Chart 3 shows the 2 year interest rate differential between Korea and the U.S. (sovereign bonds). Between the middle of 2014 until early 2016, the chart shows a strong correlation between the KRWUSD and 2 year rate differentials. As Korean rates fell relative to the U.S., the Won depreciated in line. Interestingly, in the year prior, a wide differential in favor of the Won had preceded a strong appreciation. Presently, the differential is heading in the opposite direction. South Korean 2 year rates are now 10 basis points below the U.S. The highest probability, given all the data, is that the KRWUSD converges toward the rate differential by depreciating over the next several months.
Fundamentals for the Won are Negatively Aligned
The South Korean economy is highly cyclical, and typically correlated with global growth. With exports accounting for 42% of GDP, versus the 28% global average (see World Bank data ), Korea is considered a global bellwether. That presents an interesting conundrum given recent better global growth. While South Korea initially participated in that acceleration, the recent divergence into economic weakness could be reason to doubt the resilience of global growth. Or, it could simply be that the Korean Won is overvalued, and needs to depreciate. Regardless, that represents an opportunity.
South Korea is a country with a high savings rate, which leads to perpetual current account surpluses. Yet the current account has deteriorated in the last 12 months. The Real Effective Exchange Rate, which accounts for inflation differentials versus trading partners over time, is in the 92nd percentile, indicating a significant overvaluation. Interest rate differentials are not supportive for the Won, and are moving in the wrong direction. Weakening domestic growth is also evident. Putting all the pieces together, the Won looks like a good short here. With recent market weakness, and the usual positive correlation the Won has with risk assets, a short KRWUSD position could also act as a good hedge; a global beta hedge with positive alpha.