The Kimchi Signal: Leadership in Global Equities

Our inaugural investment blog is, like most 'firsts', full of trepidation. At worst we will have found out that our competitive advantage ought to be put to work elsewhere. At best, we will have proven that our experience and passion for investing are being put to good use and can help you, and ourselves, gain clarity in the convoluted and at times cliquish world of investing.
 
Due to the export-intensiveness of its economy, South Korea is at the cross roads of the global trade network and tends to be a leading indicator of major turns in global trade. To the extent that other emerging markets mimic its export-dependent model of development, they are likely to confront similar headwinds. Conversely however, sub-sectors of equity markets in advanced economies suggest that foreign exposure is actually a blessing and not a curse, even in the current pervasive reign of trade wars. 
 
The slowdown in global trade is holding South Korea's economy hostage for South Korea has become a trade dependent economy with total trade at 77% of GDP (as of 2016, World Bank). However, the changes in the level of exports reflect the changing level of demand from the rest of the world, and according to the World Bank, exports of goods and services accounted for 42% of South Korea's GDP in 2016, which is below the 2011 peak at 56%. Further, data from the Korean Customs Service show that exports continue to plunge, forcing the South Korean government to downgrade this year's economic growth target to 2.0-2.1% from the previous target of 2.4-2.5%. While the summer banquet was rather piquant, investors are about to experience the indigestion that comes from overindulgence (the global kimchi put).
 
Consider, for example, the overlay of the multi-year Kospi index with the twelve month percent changes in global trade volumes. While it may or may not be debatable whether the Kospi is correlated to global trade when the former is trending, it does respond to major cyclical turns. For a view on the Kospi we turn to the index's technicals: it does not appear as if the downtrend in the Kospi index, and its underperformance vs. the overall emerging markets index has run its course. With further downside risk still possible for the Kospi, the warning signs for trade, therefore, remains in place.

The news-flow provide little solace: South Korea and Japan are in an all out trade-fueled dispute, the US-China and EU-UK relationship still up in the air, ditto for Mercosur-EU. In short, protectionism has the upper hand in the sphere of policy making. However, one would not think so by looking at the performance of certain sub sectors of the equity markets in advanced economies.
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US and European aggregate company revenues show a growing differential in the performance between the overall market and the universe of companies with higher than average foreign exposure. S&P 500 companies with a majority of foreign revenue exposure (> 50%) have outperformed the broad market index (and by implication their domestic-focused peers) over the past few years. A similar dynamic is seen in Europe where the outperformance of the S&P Europe 350 Index of companies with majority of foreign revenues is even larger versus the broad market. The price changes for the US S&P 500 foreign revenue exposure index is 176.3% versus 175.7% for the overall market. While the price changes for the S&P Europe 350 foreign revenue exposure index is 78.8% versus 52.8% for the overall market (40.8% versus 20.2% in US dollars, respectively). 

If there is any insight from this it is that the best defense against the headwinds of trade wars is a well integrated profitable global supply chain. Moreover, it speaks to the value of discerning company specific narratives and fundamental differentials. For instance, United Airlines is a constituent of the universe of S&P companies with higher than average earnings coming from outside the US, yet American Airlines is not included in the S&P 500 foreign revenue exposure index, though they have similar levels of market capitalization and belong to the same industry group. 
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While the warning signs for trade remain in place, what matters for global equity investors is the relative return potential of industry groups and their constituents. We intend to identify the drivers of outperformance of US and European companies with a majority of foreign revenue exposure relative to their domestic-focused peers in a follow up post. For now, our research suggests that investors consider the merits of foreign exposure within the context of global trade conditions, perhaps foreshadowed by South Korea.