South Korean and Taiwan equities have been among the best-performing globally thus far in the fourth quarter this year, and we believe, for good reason, say Dina Ting, CFA, Head of Global Index Portfolio Management, and Marcus Weyerer, CFA, Senior ETF Investment Strategist, at Franklin Templeton. 

While their Asian Tiger peers Singapore and Hong Kong returned between 2% and 9% during the quarter, South Korea and Taiwan are up 17% and 12%, respectively. Broad emerging markets have risen just under 5%.

The primary factors driving the recent surge in relative performance appear to be:
•    Investor bargain hunting
•    Semiconductor chips and Electric Vehicle (EV) market optimism
•    Strong fundamentals

How sustainable is this trend and is the time ripe for investors to take a closer look? Let's consider each element driving returns.

1. Bargain hunting

Both markets have recently seen some of their worst drawdowns in at least two decades. As of late November, the FTSE South Korea Capped Index is down 40% from its preceding all-time-high (ATH), while Taiwan's index has ceded 28%.

That is considerably less than during the Global Financial Crisis, but eclipses bear markets such as the bursting of the Chinese equity bubble in 2015-16, the 2018 US-China trade war and, for Taiwan, this also surpasses the spring 2020 Covid-19 crash.

On its own, this wouldn't be sufficient reason to consider these markets attractively valued. However, even with the prospects of a possible global recession—which is not our base case—comparatively low valuations can offer a buffer if earnings expectations were to be lowered.

While multiples have already retreated from their highs, US markets are still trading at an estimated forward price-to-earnings ratio (P/E) of 18, while Korea and Taiwan are at 10x and 11x. The discount is even more striking in price-to-book ratio (P/B) terms.

In perhaps the most notable example of potential bargain hunting, Warren Buffett's Berkshire Hathaway recently reported a new $5 billion stake in Taiwan Semiconductor Manufacturing Co. (TSMC). The news came just weeks after the US set new restrictions on sales of advanced semiconductors to China.

The move is primarily intended to hamper Chinese technology capabilities, including military applications of AI, but it is also a further step in the "decoupling" of supply chains from China more broadly. The increasingly popular "China plus one" strategy could allow Korea and Taiwan to pick up some business over the medium term.

The recent passage of the US Inflation Reduction Act, which aims to generate investments in domestic manufacturing and encourage procurement of critical supplies from free-trade partners, may have a similar effect—provided Taiwanese and Korean manufacturers manage to receive the extension on federal tax credits, for which they are lobbying.

Semiconductor chip manufacturing notoriously poses sky-high barriers to entry driven by enormous capital requirements and technological know-how, maintaining the dominance of the industry's few major players. TSMC has recently announced preliminary plans to produce advanced chips at its new factory in the western U.S. (Arizona), though the United States' global chip manufacturing share remains a mere 12% as of this year (vs close to 40% in 1990).

2. Semiconductor and EV market optimism

Bargain hunting can benefit investors in the short term, but for medium and longer-term outlooks, quality is worth assessment. Korean and Taiwanese equity markets, both dominant in the information technology sector (namely semiconductors), are also heavily composed of materials and industrials holdings - with weightings currently ranging between 14% and 23%.

Both markets host leading, highly profitable companies with wide moats and have built a robust ecosystem around them. Taiwanese companies, for example, command some 11% of the world's liner fleet.5 Given that 80% to 90% of global trade is carried by sea, that is a crucial advantage in times of disrupted supply chains, especially for an export-heavy economy.

Semiconductors: There is some timid optimism that we are nearing the bottom of the chips cycle. After a near-unprecedented chip shortage during 2020 and 2021, this year has seen the squeeze turn into a glut. Over the summer, stockpiles soared and consequently some leading firms have cut planned capital expenditures by as much as 50% for 2023.

At the same time, we are confident that capacity reductions today can morph into the price hikes of tomorrow - as has so often been the case in an industry known for its pronounced cyclicality. Generally speaking, if the semiconductor inventory cycle peaks around the turn of the year, the tech sector may have already reached its lows. 

Industrials/Materials: With the world shifting more quickly toward electric vehicles, battery demand has soared in tandem. McKinsey forecasts the market for battery cells to grow, on average, by more than 20% per year until 2030.

This bodes well for South Korea's petrochemical heavyweights, one of which is spending billions to accelerate the sustainable expansion of its battery material production lines, including a recently announced plan to construct a manufacturing facility for electric vehicle components in the southern United States (Tennessee).

3. Strong fundamentals

Lastly, we note that both Korea and Taiwan are in comparatively enviable positions when it comes to macroeconomic fundamentals. As export-oriented nations, they tend to benefit from weaker currencies. While the dollar strength came to a sudden halt as of late, both the Korean won and Taiwan dollar are still significantly cheaper compared to levels seen at the start of the year.

Among the more negative effects of a weak currency in either market is the fact that energy imports become more expensive. But with energy commodities down almost a fifth from their June highs, some relief in budgets may appear. 

With debt-to-GDP ratios of 30% in Taiwan and just under 50% in Korea, both countries remain well-positioned to withstand a global economic downturn. While debt has grown, so have FX reserves that are hovering near all-time highs.

On an annual basis, Korea is still growing at close to 3%, despite a weak third quarter with near zero growth. However, while forecasts for 2% growth next year may seem disappointing in an emerging market context, Korea should still outgrow most advanced economies. The country's GDP-per-capita is more comparable to developed, not developing, markets.

It can also benefit from a notably high rate of productivity that serves its "agri-tech" innovation well considering still looming food security issues.

Korea has ranked highest in government R&D funding for agricultural sciences among OECD nations, and it boasts impressive government blockchain initiatives, including plans for blockchain-powered networks to improve transparent food supply chains as well as another game-changer—new blockchain-based digital IDs to be implanted in smartphones and replace existing credentials.

Such IDs could potentially transform business and government efficiencies and vastly benefit Korea's digital economic foundation and metaverse buildout.

In conclusion, we think that despite the elevated risks - including geopolitical headwinds - of single county allocations, overweighting Korean and Taiwanese equities today may benefit investor portfolios given moderate valuations that may be viewed as attractively priced.

The Asia region's standing as the global driver of middle class growth should also continue to present long-term opportunities, particularly given the world's imperative green energy transition and technological advancements.

By Dina Ting, CFA, Head of Global Index Portfolio Management, and Marcus Weyerer, CFA, Senior ETF Investment Strategist, at Franklin Templeton.