EWL - EWL: May Prove To Be A Reliable Bet If You're Prepared To Pay Up

Summary

• EWL has a good track record of mitigating harmful volatility.
• Conditions for CHF appreciation look good.
• EWL’s valuations are expensive.

There's no question that when prices are jumping around, you feel different from when they're stable. - Peter Bernstein

Those who have access to the Leaders-Laggards section of The Lead-Lag Report would be aware of a chart I had put out highlighting how a ratio measuring the strength of international stocks as a function of the S&P 500 was hovering around its highest point since June 2021. Much of the interest has been driven by a shift in the narrative from "deep recession possible" to "recession might be avoided altogether".

Whereas, in our domestic shores, things are looking a lot more unsteady. For instance, as pointed out in a tweet on the timeline of The Lead-Lag Report, the CB's Leading Economic Indicator typically peaked 12 months ahead of a recession, and this occurred around a year ago!

Nonetheless, if you're cagey about things domestically and are looking for some reliable international exposure to add to your portfolio, you may consider looking at the iShares MSCI Switzerland ETF ( EWL ). Admittedly, EWL hasn't set the world alight over the last 6 months, delivering less than mid single-digit returns, while also underperforming its peers from Europe by over 4x. But I still believe there is some merit to adding a low-beta product like this to help diversify your portfolio (Just two defensive segments, healthcare, and consumer staples account for ~53% of the total portfolio).

If you've been following my commentary across various portals, you'd note that a range of my intermarket signals are currently supporting a risk-on environment, but I would urge investors not to let go of their seat belts and brazenly shed all their defensive posturing. I feel that the current pivot from defense to growth has been largely driven by some wishful thinking that all the stars are aligning. However, little regard has been paid to the notion that we may be pivoting from an era of slowing inflation to potential deflation.

Global household savings rates are coming down like a pack of cards, even as credit card usage has maxed out. There's also a lot of fanfare surrounding the reopening of China and while one can appreciate how useful this could be for the Chinese, I worry about the glut of Chinese goods that could flood the markets and fast-track the shift from inflation to deflation.

If this were to come through, risk sentiment would go for a toss and one would expect a spike in volatility.

If risk-off conditions pick off, you ideally want some part of your portfolio to fare well during a downturn, and that's where something like EWL could help.

Look at how well EWL fares here when compared to a diversified basket of European stocks. Firstly the standard deviation of its monthly returns is lower than the ETF EZU, but crucially look at how well it fares when faced with harmful volatility. The superior differential in the Sortino ratio has been consistent all through the last 10 years and is currently at 0.62x, even as EZU throws up a lower figure of 0.4x. The landscape going forward may not be identical to what's seen in the past, but there's a reasonably good probability that EWL will do a better job than EZU when faced with ample downside deviation.

The other thing I'd like to highlight is the favorable dynamics with the USD/CHF. I feel that investors in the US are giving undue attention to the headline Q4 GDP number of 2.9% without considering the vulnerabilities in the core elements of the report. Besides, much of the increase in Q4 growth came on account of a buildup in inventories ahead of the holiday season. But data from Census will tell you that inventories remain quite high relative to sales, and would need to be unwound in the quarters ahead at promotional rates. Besides a weak economy, it also doesn't help that the Fed is unlikely to offer too much of liquidity support, which should diminish the allure of the dollar. The US Fed also isn't best placed to keep lifting rates considering the risk to debt servicing when the Debt to GDP ratio is already so high.

Conversely in Switzerland, the central bank which kept rate in negative territory for the past 7 years is in the process of lifting rates, and even though there have been ample rate hikes in H2-22 (three times), things are unlikely to ebb any time soon. In fact, local economists in Switzerland think we could see another 100bps worth of hikes in 2023. Besides, the national debt levels in Switzerland are a lot more well managed.

I also don't believe the Swiss central bank is in the best shape to make substantial interventions in the forex market. As noted in The Lead-Lag Report, last year, it took a big hit on its FX positions which would likely represent 18% of GDP. This also means that it has not been able to make its usual payouts to the government and member states. Without ample central bank intervention, I would expect the CHF to appreciate, even as it attracts flows as a safe haven play. What also aids the CHF narrative is the fact that COVID-related fiscal support is being withdrawn and Switzerland is poised to report a fiscal surplus in 2023. This will likely attract greater foreign flows to Swiss-denominated assets.

Technically, the USD/CHF pair too is not in great shape, after it recently broke down below a 2-year uptrend. Given how long that trend was in place, it won't be easy to recoup.

Conclusion

While the case for EWL as a defensive play looks attractive, investors should recognize that they are unlikely to get ample earnings growth for the premium multiple they'd be shedding out. According to YCharts , you'd only get long-term earnings growth within the mid single-digit terrain, whereas an EZU could give you more than double that level at 11.5%. Besides the valuation differential is quite a lot with EWL trading at 16x forward P/E, A 42% premium over EZU.

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