Dragged down by weakening external demand, investment in facility and construction slumped -5.2% quarter-on-quarter and -0.3% quarter-on-quarter respectively in 4Q 2011. On a yearly basis, the growth of facility investment fell into the negative territory for the first time since 3Q 2009 while construction investment was down for the 7th consecutive quarter in 4Q 2011 (see Chart 1). As a result, gross fixed capital investment contributed -0.6% points to the Korea’s GDP growth.
Chart 1: Capital Investment Shrinks In 4Q 2011
Global economic slowdown and the European debt crisis have hurt Korean business sentiment and their willingness to invest. The Bank of Korea’s (BoK) Business Survey Index (BSI) shows that manufacturing facility investment index has continued to remain below the benchmark 100 mark since October last year. An index reading below 100 represents that pessimists outnumber optimists. The index was also below its historical average of 97 mark (represented by red line in Chart 2) for the third straight month in February 2012. It reflects the country’s manufacturers are still concerned about the economic uncertainties amid fragile domestic demand.
Chart 2: Poor Business Sentiment Limits Facility Investment
Facility investment will pick up gradually
Since exports growth is expected to slow further, we do not expect to see a sharp rebound in facility investment. Still, a persistent decline is highly unlikely given the pressure to expand production has soared. We believe facility investment will improve moderately in 2012 as the gap between output and production capacity widens.
The Pressure Of Investment Climbs
Although the average export growth rate slowed from 24.4% year-on-year in 1H 2011 to 15.8% year-on-year in 2H 2011, the gap between export volume growth and capacity growth has remained positive as the latter grew slowly last year (see Chart 3). Export volume growth consistently outpaces capacity growth indicates manufacturers face mounting pressures to increase investment. Indeed, the pressure of investment (industrial production growth – production capacity growth) has consistently stayed flat and remained positive in 2011 even though exports growth has weakened. Chart 3 demonstrates that the pressure of investment and the spread between output and production capacity typically have a strong correlation with facility investment. Historically, facility investment tends to grow when the pressure of investment and the spread between output and production capacity stay positive. However, we have seen a divergence in 4Q 2011 when facility investment dropped -3.4% year-on-year. It indicates the poor business sentiment reduced their willingness to invest, despite capacity figure suggests manufacturers should increase investment.
Chart 3: Pressure On Facility Investment (Production Growth – Capacity Growth) And Facility Investment
Leading indicator Of Investment Flashes Positive Signs
Chart 4: Machinery Orders And Estimated Facility Investment (3-Month Moving Average)
Still, machinery orders, a leading indicator of capital investment, has sent positive signals over the past couple of months. The 3-month moving average of machinery orders rose 11.7% from a year earlier in December 2011, marking the 16th consecutive monthly increase. The growth rate has accelerated to double digits in 4Q 2011 after narrowing to as low as 1.4% year-on-year in September 2011 (see Chart 4). Chart 4 also shows machinery orders always change before the estimated equipment investment will change. Given their high correlation, it is rare to see the growth of estimated equipment investment (red line, to reflect capital investment) turned negative when the growth of machinery orders (blue line) still stays positive. The last time that these two figures diverged from each other was back to the fourth quarter of 2003. However, the divergence was short-lived as estimated equipment investment finally followed the upward momentum of machinery orders in February 2004.
Construction Investment Shows Sign Of Bottoming Out
Construction investment remained subdued in last year due to sluggish residential construction and civil engineering investment. South Korean’s house prices and sales have entered into a downturn since 4Q 2010 after the government took measures to cool down the over-heating property market. However, we believe construction investment will bottom out in 2012, thanks to the government’s plans to help the struggling property market. In December 2011, the government announced to remove the additional capital gains tax on owners of more than one property. The government is planning to take more relief measures like reducing the mortgage rate for the first-time home buyer with annual incomes below a certain threshold. In fact, residential construction investment shows signs of improvement over the past few months. For example, construction orders and the building permit area have started to pick up since October last year (see Chart 5); the number of unsold apartment units has dropped to a multi-year low level in 2H 2011.
Chart 5: Construction Orders Pick Up
The civil engineering investment will remain stagnant in 2012 because the Korean government announced that the amount of social overhead capital (SOC) investments will be only 22.6 trillion won, 7.4% or 1.8 trillion won smaller than in last year. Therefore, overall construction investment is forecasted to grow marginally, mainly led by residential construction investments and favourable base effects.
Export Growth Is Likely To Slow To a Single-Digit Pace
Based on our house view, the Eurozone will experience a mild recession while US economy will expand slowly in 2012. Korean exports, which grow at a CAGR of 24% over the past two years, are inevitably battered. Korea posted its first trade deficit in 24 months in the first month of this year. The country’ trade balance recorded a deficit of US$ 1.96 billion, a sharp turnaround from a surplus of US$ 2.9 billion from a year earlier. Exports unexpectedly slumped 6.6% year-on-year in January, marking the first decline in 27 months. The Ministry of Knowledge Economy attributed the drop to the global economic downturn and the European debt crisis.
Chart 6: Downturn In Developed Economies Hurts Korean Export Volume
Again, we can also look at some indicators to observe the export trend. OECD Total Composite Leading Indicator (CLI), which is highly correlated with Korean export volume, has been in a downtrend since 2H 2011 (see Chart 6). Spotlight on the OECD CLI has increased because of its function to provide early signal of turning points in business cycle. For example, the growth of this index turned red for 22 consecutive months since November 2007. The growth of CLI has persistently remained at the negative territory since June last year, reflecting the deterioration in global economic outlook. Therefore, we are not surprised to see a downturn in Korean export volumes.
Chart 7: Slower Growth In Commodity Prices Weighs Down Korea’s Export Prices
Moreover, the CRB Index, which represents commodity prices and is closely correlated to the country’s export price, has continued a downswing (shown in Chart 7). Stripping out the political events which are difficult to predict, the global economic slowdown will likely weigh down the international commodity prices. The growth of the country’s export prices will slow significantly.
Some analysts may still argue that Korean exporters can weather the storm of the slowdown as the country’s total export to non-G3 markets (including US, Europe and Japan) exceeds 70%. We heard the same story in 2008 but the truth is that Korean exports suffered a big drop during the financial crisis period (declined at a double-digit rate for 10 consecutive months since November 2008).
However, unlike in the period from late 2008 to mid 2009 when demand from US and Europe plunged significantly, shipments to US which accounts for 10% of Korean total exports, has been far resilient than what markets previously thought (see Chart 8). As we believe the US economy is set to grow slowly in 2012, exports to US are forecast to grow moderately. Besides, we believe China’s economic growth story will continue to be strong in 2012. Thus, exports to China (24% of Korean total exports) will remain the major driver of the overall exports growth. The only concern is exports to Europe (10% of Korean total exports) which dropped 44.8% year-on-year in January 2012 (see Chart 10). We think shipments to euro zone will continue to drag down the country’s total exports growth. As a result, we expect the overall exports growth will slow to a single digit rate.
Chart 8: Exports To US
Chart 9: Exports To China
Chart 10: Exports To Euro Area
Growing But Challenging
The disappointing GDP growth in 4Q 2011 fuels worries about the Korean economic prospect. Some commentaries forecast the economy would dip "drastically" this year with GDP growth in the first half probably falling to near 0%. Their arguments are mainly that consumption unexpectedly cools while exports growth is losing stream in which we disagree. Based on our findings (listed in Table 1), private consumption and facility investment will grow moderately while export growth will slow down at a faster pace especially in 1H 2012. We admit that the uncertainties concerning the external economic environment could affect the country’s exports as well as business investment whereas oil price uncertainty arising from political unrest in MENA could add risk on domestic demand. But this will not derail the country’s sustainable economic growth in 2012 as domestic factors will play a more important role. We believe corporate earnings growth will continue to benefit from this development and thus maintain our 5 star "very attractive" rating on the Korean equity market.
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