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The Korean stock market will likely face great changes, both externally and internally, in 2005. Externally, the incumbent administrations of the US and China are having second thoughts on the expansionary monetary policies previous governments held for years. Until recently, the two super economies had helped the global economy generate dazzling growth although confidence in employment and consumption recovery remained weak. But in 2005, the two governments plan to cool down their economies.eg, by raising interest rates to curb asset-price inflation. We expect a market correction in 1H05. Global tightening trends should slow economic growth, and thus corporate earnings estimates will likely be revised down. After massive inflows of foreign capital into the Asian market in 2004, little liquidity is expected from overseas in 2005. If foreign investors start selling off holdings, domestic institutional investors alone would not be able to hold up the market. Furthermore, businessenvironment uncertainties make it difficult to predict how far and for how long the economic slowdown will continue. In 2H05, with downward earnings revisions wrapping up, we believe the domestic stock market will have a chance to start to re-rate, on increasing long-term investment by domestic institutional investors. However, we do not expect the KOSPI to break through the 1,000-pt threshold, as hopes will likely be disheartened by weaker growth potential in the wake of falling capex investment. We expect the KOSPI to range between 740 and 980 pts in 2005. Summary The Korean stock market will likely face great changes, both externally and internally, in 2005. Externally, the incumbent administrations of the US and China are having second thoughts on the expansionary monetary policies previous governments held for years. Until recently, the two super economies had helped the global economy generate dazzling growth.although confidence in employment and consumption recovery remained weak. But in 2005, the two governments plan to cool down their economies. eg, by raising interest rates to curb asset-price inflation. We believe it is in this context that the US is supporting a weak dollar policy. We expect worsening export conditions to force Korean companies to turn to the domestic market, but are skeptical of an early consumption recovery. Internally, we expect an improved supply/demand balance in the Korean stock market in 2005, with pension funds increasing equity investments, and other institutional investors selling less than before. Institutional investors could become net buyers if more opt for long-term investment (following in the footsteps of pension funds). If so, individual investors will likely sell fewer shares. All in all, the abrupt, heavy sell-offs that in the past have often sent the market tumbling to unjustified levels should decrease. At the turn of each year, expectations grow that the Korean stock market will finally end its range-bound movement. Such expectations appear to be particularly high for 2005, but we do not expect them to become reality in the foreseeable future. An improved supply/demand balance alone cannot enable a re-rating. Moreover, Korean exporters heavily depend on commodity-price hikes for earnings growth, which raises concerns, given the volatility inherent in commodity prices. We expect a market correction in 1H05. Global tightening trends should slow economic growth, and thus corporate earnings estimates will likely be revised down. After massive inflows of foreign capital into the Asian market in 2004, little liquidity is expected from overseas in 2005. If foreigner investors start selling off holdings, domestic institutional investors alone would not be able to hold up the market. Furthermore, businessenvironment uncertainties make it difficult to predict how far and for how long the economic slowdown will continue. In 2H05, with downward earnings revisions likely wrapping up, the domestic stock market will have a chance to start to re-rate, on increasing long-term investment by domestic institutional investors. However, we do not expect the KOSPI to break through the 1,000-pt threshold, as hopes will likely be disheartened by weaker growth potential due to falling capex investment. We expect the KOSPI to range between 740 and 980 pts in 2005. Liquidity rally to peter out Year-end liquidity rally in progress Global stock markets are rallying. Economic momentum has slowed, but modestly, and interest rates have remained low. The US reflationary policy has generated more investment and boosted asset values, but real interest rates have remained low.as investment and consumption growth has not been robust enough to allow for bold interest-rate hikes. While partly implementing tightening policies, China has continued to emphasize growth. The Korean stock market, sensitive to US interest-rate hikes and China's tightening policies in 2Q04, has been seeing liquidity rallies since 3Q04, backed by record-low real interest rates and stable economic data in the US and China. Conditions for liquidity rally weakening Investment returns higher than opportunity costs can sustain a liquidity-driven rally, even if economic momentum is weak. As exports are the most crucial variable, we use changes in OECD leading economic indicators as a proxy for investment returns, and US real interest rates (based on 10-year TB yields) as opportunity costs. The gap between the two has widened recently (chart 2). Now that oil prices have fallen and consumer indices have stabilized following the US presidential election, the US stock market has been rallying. Nevertheless, additional interest-rate hikes and slowing growth should gradually narrow the gap. As such, the current liquidity rally in Korea will likely weaken. Meanwhile, the Bank of Korea (BOK) has cut interest rates due to depressed domestic consumption, diverging from the policy stance taken by other countries. However, any additional rate cuts by the BOK will likely be of limited depth, given that yields on Korean government bonds could fall below those on their US counterparts, and the real effect of expansionary monetary policy is questionable. Yield spreads in emerging markets narrowing Foreign investment in emerging markets has been greater than expected in 2004, sending bond prices soaring. Such a trend can be sustained either by low opportunity costs in advanced markets or high investment returns in emerging markets. If interestrate hikes continue in advanced markets, opportunity costs should gradually rise. On the other hand, investment returns in emerging markets will likely see limited upside, given that their growth should slow as the benefits of low labor costs and rising raw-material prices fade away. With the spreads between government bond yields in emerging markets and US TB yields narrowing and approaching the previous lows of Apr 2004 (when economic momentum peaked), emerging markets should receive lower risk premiums, which would be positive for share prices.the KOSPI has rallied this year under such a scenario. However, we do not believe the spreads will narrow further if liquidity decreases. Additional capital inflows unlikely The spreads between the US and Korea's five-year government bond yields are close to zero. If the US Fed raises rates further, yields on US five-year TBs would surpass those on their Korean counterparts. The persistence of such a trend would imply a long-term depression for the Korean economy, possibly inducing capital flight to overseas. There could be the expectation that capital would flow into the stock market.but in Korea, there are few precedents of low interest rates moving liquidity from bonds to equities; capital has more often been seen to flow into overseas bond markets. It would not be easy for domestic investors, seeking more than investment returns when shifting from bonds to equities, to turn to the equity market in the absence of clear, long-term prospects for the Korean economy. US, China to shift to tightening Incumbent US administration seeking to tighten belt Prior to November's presidential election, the US government had focused on buoying consumer spending through strong US dollar and expansionary monetary policies. With the election over, we expect Washington to eventually ditch its expansionary policy ( ie, fiscal expansion and tax cuts), which may have been prudent politically, but not in terms of fiscal soundness. Still, a sudden shift is unlikely in the near term, given President Bush's campaign pledge to expand fiscal spending. To reduce the US trade deficit and increase tax revenue, the US government is simply resorting to currency devaluation, which is far easier than taking full-scale tightening measures. In time, however, the new administration will likely move harder to reduce the US fiscal deficit. Won/US$ rate falling The US dollar has begun depreciating alongside market anticipation of policy changes. We expect the won/US$ rate to initially move hand in hand with the yen/US$ rate. The yen/US$ rate stood at Y104/US$ as of Dec 9, but could fall as low as Y95/US$ (the lowest point since the 1990s).assuming that the yen/US$ rate changes to the same degree as the euro/US$ rate and push down the won/US$ rate to W950/US$ (assuming a won/yen rate of W10/Y). That said, dollar depreciation should have its limits, as East Asian countries are key investors in US treasury bonds. Our economist forecasts that the won/US$ rate will eventually return to the W1,100/US$ level, as the market is aware of the hardships Korea will likely experience in the face of slow exports and continuing depressed domestic consumption. Should the won/US$ rate fail to rebound and stay below W1,100/US$ for a prolonged period, Korean businesses would be dealt a blow. Won appreciation negative for stock market In the past, there have been times when Korean share prices have risen despite a strong won. But these times coincided with a booming economy and growing exports. Indeed, the impact of a strong won differs depending on its cause. In times of strong exports and a solid trade surplus, won appreciation may not be a big deal. But steep won appreciation driven by external factors is negative for exporters earnings. Moreover, unlike previous years, the won is strengthening as exports are slowing. Our sensitivity analysis suggests that the won appreciating to W1,000/US$ (from the current W1,125/US$) would reduce the average operating profit of the Samsung Universe by roughly 8%. The effect of a strong won on the stock market would likely be amplified, as its major victims would mostly be large caps focused on exports. In addition, the won has already risen around 10% against the Chinese yuan, which could erode Korea's competitive edge over China. US and China to make additional rate hikes The US Federal Reserve has raised interest rates four times since June, but should eventually increase its benchmark-rate target to at least 4%. China's central bank raised its base interest rate by 0.27% in November.though this was mainly a symbolic gesture aimed at expressing its tightening policy orientation.and will likely raise the rate once or twice more, depending on market response. Inflationary pressure is growing in both the US and China. Following rises in real-estate and oil prices, service-price ( eg, labor cost) hikes are looming. Thus, both countries appear to feel it is imperative to raise interest rates now. ie, that belated hikes would be less effective. As the new governments in the US and China adopt tighter monetary policies, the global economy should grow at a slower rate. Possibility of global economic slowdown increasing Interest-rate hikes and a weakening US dollar should slow US consumption growth. To prevent this from inducing a global economic slowdown, Asian and other economies will likely have to become bigger consumers. But we doubt they can afford to do so. China needs to cool down its economy further, the Japanese economy is likely to grow at a slower y-y rate in 2005 (although its long-term prospects are bright), and Korea is unlikely to see a significant recovery in domestic consumption. As such, we feel a global economic slowdown is highly likely.