SPY - EWG: Challenges Loom Amid Economic Headwinds And Lack Of Potential

2023-09-06 10:03:16 ET

Summary

• iShares MSCI Germany ETF offers concentrated access to the German market with a focus on large-cap to mid-cap companies.
• Risks associated with investing in German markets include inflation, potential recessions, ECB policies, and challenges faced by German companies.
• An alternative ETF option with lower costs may be a better choice for investors considering the German market.

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Introduction

Welcome to my analysis of the iShares MSCI Germany ETF ( EWG ). In short, the investment case for this ETF focuses on large-cap (90%) to mid-cap (10%) German companies, offering investors concentrated access to the German market.

In the following analysis, I will explain why EWG may not be the perfect investment opportunity for your portfolio. I will discuss the various risks associated with investing in German markets, including inflationary risks, potential recessions, European Central Bank policies, and the challenges faced by companies in Germany. Additionally, my article will cover cost structures and historical performance. Towards the end, I will present an alternative ETF option with lower costs for those who are still inclined to invest in this market despite the risks.

This article primarily reflects a subjective perspective and is intended to serve as inspiration for potential investors considering this ETF or those who are looking to get market exposure to the German economy.

Holdings And Compositions

Regarding holdings and sector exposure , EWG is well-diversified within Germany, with positions weighted based on market capitalization. The top three positions and the most prominent companies are SAP SE ( SAP ) (11.07%), Siemens AG ( SIEGY ) (8.71%), and Allianz SE ( ALIZF ) (7.52%). The ETF holds 69 positions, indicating a higher level of diversification within Germany compared to indices like the DAX , which typically includes fewer than 40 stocks.

The sector distribution includes Financials (18.28%) in the top spot, followed by Industrials (17.35%) and Consumer Goods (16.29%).

ETF Details

EWG posts a Total Expense Ratio of 0.50% .

Furthermore, EWG boasts a comparatively low Price-to-Earnings (P/E) ratio of 12.93 , suggesting potential for favorable performance. In comparison, an S&P 500 ETF ( SPY ) has a P/E ratio of 17.86 . However, this valuation difference seems justified, at least for the moment, as the U.S. market is not subject to the same risks that affect the German economy and its stock market. I will discuss these risks in detail later in the article.

The ETF's Assets Under Management ((AUM)) stand at $1,567.1 million , which may be modest in the overall context but still reflects significant market interest in this segment. However, lately the ETF has experienced some outflows, indicating that investors are leaning towards more caution regarding the German economy and its worries.

Also, for investors seeking regular cash returns, the ETF offers a dividend yield of 2.74% . However, this may be considered relatively low for growth and value stocks from Germany. To provide a point of comparison, the DAX ( DAX ) index distributes an annual yield of 3.4%.

Inflationary Pressure & Looming Recession

Consumer price inflation in Germany currently stands at 6.1% year-over-year , significantly higher than in other EU countries such as Belgium and Spain, which are nearing the ECB's 2% target mark again. Additionally, German officials have displayed a certain degree of incompetence in addressing the inflation issue, which poses a significant risk. While it is undoubtedly challenging for the average consumer, German officials have resorted to issuing several government checks to citizens to alleviate some of the price pressure. While this may appear noble on the surface, there is a concerning divergence between fiscal policy and monetary policy that should ideally be aligned, especially during times like these. If this divergence becomes too pronounced, it carries the risk of triggering shock events similar to the UK gilts crash in 2022 . Furthermore, such a divergence in fiscal policy, rather than effectively addressing the core reasons for price increases, fails to bring down inflation. A few examples of this fiscal divergence include the €9 train-ticket, fuel discounts, personal energy subsidies, and other payments to the German population.

Additionally, the conflict in Ukraine is contributing to the persistence of inflation in Germany due to a spike in energy prices, which peaked in 2022. While prices have lowered since then, they still remain elevated and hence might be the biggest drain on the German economy.

The inflation target set by the European Central Bank ((ECB)) of 2% is clearly being missed. Since July 2022, the ECB has raised interest rates nine times, totaling a 4.25 percentage point increase. The most recent rate hike occurred at the end of July.

The German Institute for Economic Research and economists at Deutsche Bank have recently lowered their growth forecasts significantly, anticipating a 0.5% contraction in Germany's economic output for the full year 2023.

In that context, Economic growth has stagnated in the summer quarter, and I expect Germany to slip into recession probably over the course of Q4 2023 - Q1 2024.

Challenges in Combatting Inflation As mentioned earlier, combating inflation through interest rate hikes may not be effective since essential commodities like food and energy, which are driving inflation, are part of basic consumer needs, and the core reason for the elevated price increases lies beyond the ECB's control.

Rising prices are not necessarily curbing consumption and therefore inflation, but these tighter financial conditions certainly act as a tight grip on companies, therefore leading to slower economic growth while prices remain elevated. Also, there is expectation of political and societal pressure to raise wages, which could, in turn, accelerate inflation even further, which is a serious threat given the power of German unions and the reigning left-wing German government.

Performance

With a year-over-year return of 26.37%, EWG stands at the top of the performance chart, as indicated in the graph. FLGR closely follows with a performance of 26.18%. In the one-year comparison, all these funds outperform the S&P 500's ( SPY ) 14.15% return.

However, in the five-year comparisons, the S&P 500 surpasses all the two significantly.

Alternatives

Focusing on performance, EWG can indeed represent a short-term investment option, assuming it carries the recent momentum taking place in German stocks. However, in the long term, it is likely to be outperformed. Due to cost considerations, I would advise against purchasing EWG and recommend considering similar ETFs such as FLGR as an alternative. One key differentiator is that FLGR offers cost savings, which can have an impact on overall long-term performance, as clearly demonstrated in the graph. The Franklin FTSE Germany ETF posts an expense Ratio of merely 0.09%.

Conclusion

While EWG offers diversified exposure to the German market, its forward performance is heavily influenced by the complex economic landscape in Germany.

The inflationary pressures and the looming recession pose significant concerns for investors in EWG. Germany's struggle to control inflation, along with political decisions, raises uncertainties about the country's economic stability. The conflict in Ukraine and its impact on energy prices to this day further add to the cloudy economic outlook.

Despite its recent strong performance, EWG may not be the best long-term investment option due to these economic headwinds and other factors such as the relatively high expense ratio compared to similar ETFs and the relatively low dividend yield compared to other stock baskets like the DAX.

Given those factors, I see a lot of risks, whereas the German industry this ETF provides exposure to lacks potential. Which makes up for a rather poor risk-reward ratio. Hence, I firmly put out a "Sell" rating for EWG.

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