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Election Jitters and a Tidbit on South Korea

(November 9, 2006)

Dear Subscribers and Readers,

With the Democrats taking over the House and most likely the Senate as well, it is time for a new era in American politics.  However, it is still too early to discuss things such as the possible roll-back of President Bush's tax cuts (which are due to expire at the end of 2010), defense spending, and so forth.

Defense stocks (Lockheed Martin, Northrop Grumman, Raytheon, Boeing, General Dynamics, etc.) took a hit in general, as investors believe that Congress will cut defense spending going forward.  While that may be true on a longer-term basis, this author does not see any impending cuts over the next six to nine months.  Anything beyond that, it is still too hard to tell how much Congress will cut defense spending.  My guess: It is not going to be that significant.

Jason Trennert of Strategas Research Partners, for example, actually believes that defense spending will increase substantially around the world going forward – as military tensions continue to rise with the recent nuclear testing from North Korea and the strategic rise of China.  For example, the new Prime Minister of Japan – with broad political and popular support – has made it clear that he wants to revise the Japanese Constitution in favor of increasing defense spending and in Japan playing a more activist role in geopolitics.  Taiwan is also likely to increase its defense spending significantly, as China continues to exert its military power in the region.  Even Germany is getting into the act, as its cabinet has just approved guidelines to increase the amount of peacekeepers to be ready to deploy around the world.  I am also “optimistic” on defense spending in most of Western Europe going forward, as the rise of Russia in the region (along with defense spending by Russia) has significantly ramped up in recent years given the rise in oil prices.

To some extent, this increase in defense spending across the democratic and developed nations is a response to projected cuts in U.S. defense spending, but it is also a response to the fact that U.S. are too heavily occupied with both Afghanistan and Iraq – and one could argue, to the entire Middle Eastern region.  But it is also a response to the rise of both China and Russia, as both of these historically powerful countries' powerful economic growth over recent years allow them to increase their defense spending and to exert their power in world geopolitics.  For Russia – after having been one of the most powerful countries since the end of World War II, this cannot come soon enough, and make no mistake: President Putin will definitely strive to exert as much power in the region and in the world as possible.  As for China, one could argue that it was in fact the most powerful country for much of the last millennium until the late 1700s – when Great Britain started to industrialize its economy.  Just like Russia, China have and will continue to play a role in world geopolitics going forward, and countries such as Japan, the UK, Germany, France, and India will no doubt try to rise up to the challenge by increasing their defense spending as well.

As illustrated by the following chart courtesy of Strategas Research Partners, there is still lots of room for a continuing increase in world defense spending – given that most countries are only spending half as much (on a percentage of GDP basis) as the U.S. and China – and as the world economy continues to experience decent growth for the foreseeable future:

Top 10 GDP Countries and Military spending as percentage of GDP

Moreover, from a historical basis standpoint, a defense spending amount of 4.1% of GDP (the 2006 military budget is $466 billion) is actually relatively small, as U.S. military spending was as high as 15% of GDP back in the 1950s and 9.4% in 1968 during the peak in hostilities in the Vietnam War. And finally – given that the U.S. is still mandated to maintain a military force that can fight two simultaneous wars – the chances of a significant cut in military spending going forward is very little.  In fact, this author would argue that defense spending around the world will most likely continue to rise instead of fall from now until at least the end of this decade.  Buy selected defense stocks on any weakness.

Interestingly, this recent mid-term election has also been causing the most anxiety among retail investors in recent decades – as evident from the continual outflows in domestic mutual funds and just from anecdotal experiences and stories in general (many folks called a four-year low inevitable as the election approached and when that scenario failed to pan out, they started calling a fall after the election to be inevitable).  Unfortunately for the bears, this scenario has not panned out.  But fortunately for the bulls, this scenario has caused many retail investors to “sit out” from the stock market even as stocks have continued to rally.  Coupled with the fact that many global macro hedge funds are still underinvested in U.S. domestic equities, and coupled with the fact that many “quantitative hedge funds” have continued to short the stock market as a hedge to their short volatility position in recent years (according to GaveKal, this trade has worked beautifully from 2000 and onwards but have stopped worked since July of this year) – there is now a good chance for another significant rally in the stock market going into the end of this year and possibly going into spring of 2007.  For our subscribers who currently have long positions in the stock market: Continue to hold and watch your stocks on a selective basis.  We are nowhere close to the top just yet.

In terms of sentiment, valuation, and the amount of speculation in the stock market and financial markets, we are not close to the top yet – either domestically or on a global basis.  Besides the possibility of another blow up in the hedge fund complex (which may arguably have no effects at all given the muted reaction to  the recent collapse of Amaranth Advisors and to Refco in 2005), this author does not see any possibility of an exogenous shock to the financial system – Iran and other terrorist attacks notwithstanding.  However, it has always made sense to keep track of as many countries, economies, or large cap companies as possible for signs of impending “shocks.”  After all, the secrets to making outsized gains in the stock market or anything else is to be just one step ahead of the next guy.  In the case of investing or speculating in stocks, this informational advantage does not need to be large or have a significant lead-time (even a one-day “advanced notice” is already ample enough).

Given the above mandate, I am now going to take a quick look at a few issues that may be an impediment to the South Korean economy over the next decade.  One of the fastest growing economies in the world prior to the Asian Crisis in 1997 (when GDP expanded at an annual basis of approximately 8%), the potential economic growth of South Korea has not decreased significantly to approximately 4% - primarily due to slowing productivity in recent years as it transitions from an industrial/manufacturing to a knowledge worker-based economy.  According to a recent IMF paper, potential growth is projected to further decrease going forward – falling to only 2.5% by 2030 as the absolute number of the Korean labor force is set to decline starting in about 15 years.

That's right – South Korea, just like other developed economies, is also experiencing very low birth rates and a rapidly aging society.  In fact, the birthrate in South Korea now stands at only 1.1 per woman, compared to 1.3 in Japan, 1.4 in Europe (including Eastern Europe), and 2.0 in the United States.  Given that South Korea does not have an effective immigration policy, it is definitely not an exaggeration to say that South Korea will have a little bit of a problem in its hands going forward.  By 2026, the elderly population (those over 65 years of age) is set to increase to 20% of the entire population of the country.

Following is a chart showing South Korea's projected potential economic growth – straight from the projections of the IMF:

South Korea's Potential Output Growth (No Reform)

As I mentioned earlier, this disappointing growth in potential economic growth has two primary drivers: 1) slower productivity growth, and 2) slower labor force growth and even a decline in the labor force in 15 years.  Productivity increases in recent years in the service industry has especially been disappointing – particularly in the retail sector where “mom and pop” shops still play a dominating role in the country's economy.  Interestingly, however, South Korea has already begun deregulation in the retail sector very early on, as discussed by the IMF paper.

The first major reform took place in 1996 when limits on the number and size of stores for both domestic and foreign retail firms were eliminated, allowing the establishment of large-scale discount stores (hypermarkets). At the same time, foreign commercial presence in department stores and shopping centers was permitted, and foreign land ownership restrictions were eased. In 1998, the government allowed the construction of hypermarkets in quasi-industrial zones and relaxed restrictions on their establishment in natural greenbelt areas. These reforms provided a more conducive business environment, and the number of large-scale discount stores rose from 34 in 1996 to 304 in 2005. At the same time, the reforms also attracted foreign direct investment. Three (Carrefour, Wal-Mart, and Costco) of the top twenty retailers were foreign-owned, and a partnership between Samsung and Tesco was formed in 1999. However, Carrefour and Wal-Mart have recently decided to leave the market, selling their stores to Korean retail groups.

If it had not been for the deregulation that has already taken place in the mid 1990s, the productivity of the retail sector would be even lower than what it is today.  But as I am writing this, the country's retail trade is still 90% owned by “mom and pop” shops (retail operations hiring less than four employees).  Of course, the Wal-Mart haters would love to live in a world like this – but I doubt any of these workers in these “mom and pop” shops are getting any retirement or healthcare benefits either.

According to the IMF, productivity in other aspects of the service industry is also relatively low, for the following reasons:

  • Extensive entry barriers remain across the service sector. … restrictions in accountancy services in Korea are amongst the highest in the OECD. For example, there are residency requirements as well as restrictions on the establishment of foreign accounting firms and on investment by non-professional investors. The commercial presence of foreign law firms is also prohibited, and foreign qualifications are not recognized. In social services, only non-profit organizations can establish a school or hospital, and the leasing of educational buildings and land is not permitted. Meanwhile, restrictions on foreign ownership in telecommunications as well as foreign content quotas for broadcast and cable television are also in force.

  • Firms are faced with high startup costs. According to the World Bank (2006), Korea ranks 97th out of 155 countries in terms of the ease in starting a business. It takes on average 22 days to launch a business, at a cost of over $2,000, compared to 3 days and about $252 in Canada, which is ranked first. These factors discourage new firms from entering the market, limiting incentives for incumbent firms to increase their efficiency.

  • Financing is constrained. Firms in the service sector have difficulty obtaining financing to grow and become established, especially in light of high innovation costs, and therefore remain as mom-and-pop stores. This is partly a result of firms' limited collateral for securing credit (under current collateral laws) and the underdevelopment of the venture capital industry to support innovative start-ups. In an OECD study (2005b), service firms identified the financing constraint as the most important barrier to innovation, which is essential for the growth of the service sector.

  • Exit costs are high. There is little incentive for weak firms to close due to government subsidies and the high cost of restructuring associated with an inefficient bankruptcy system. According to a survey by the Presidential Commission on Small and Medium Enterprises (2005), only 3 percent of the self-employed (businesses with less than five employees) were willing to shut down their business despite poor revenue prospects, with most intending to continue, or relocate or change the type of business activity instead. In a survey of 500 retail stores in Seoul by Korea Chamber of Commerce and Industry (2004), most retailers were relying on the government to provide tax reduction and financial support, and to impose tighter restrictions on large-scale retail stores, to improve their profits rather than trying to raise productivity by training or adopting new technology.

Conclusion: In the short-run – the stock market in South Korea is still quite frothy but from a structural standpoint, there is still not too much to worry about, as yet.  For one, this author is optimistic that South Korea will carry out the suitable reforms going forward.  For example, according to the IMF:  “The Korea Fair Trade Commission (KFTC) abolished or reformed 56 anti-competitive regulations in 2004 and is currently reviewing 94 additional regulations, while many regulations on foreign direct investment have been reformed. The KFTC also launched a two-year review of the existing 8,000 regulations in 2005. In addition, regulations on admission into the legal and accounting services have been eased.” Moreover – despite the low birthrate in the country, the labor force is still expected to keep growing until the late 2020s or the early 2030s – and this can be further pushed back if the female participation rate (which, at 50%, is one of the lowest in the developed world compared to 61% in Japan and 69% in both the U.S. and the UK) increases going forward.  Overall, the prospects of South Korea still looks bright for now, especially given the population's strong academic achievements (ranks second on international achievement test), high increases in R&D expenditure (at 3% of GDP, which ranks fifth in the world), and its high penetration rate of internet broadband connections (number one in the world).

Signing off,

Henry To, CFA

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