SPY - IEV: High Expenses Amidst Economic Concerns And Monetary Policy Headwinds

2023-08-22 11:50:30 ET

Summary

• The iShares Europe ETF provides exposure to a diversified portfolio of European companies, tracking the S&P Europe 350 Index.
• IEV has a low-risk profile, but its expense ratio is relatively high compared to similar ETFs.
• The European economy faces challenges from inflation and aggressive monetary policies, which may impact the performance of IEV.

Introduction

Welcome to my in-depth analysis of the iShares Europe ETF (IEV). As the name suggests, this ETF focuses on the European market, offering investors exposure to a wide range of European companies.

By tracking the performance of the S&P Europe 350 Index, the iShares Europe ETF provides a diversified portfolio of 350 stocks, spanning various geographic regions and economic sectors.

Managed by iShares, a BlackRock company , the iShares Europe ETF has been an investment option since its inception more than two decades ago.

With its market capitalization-based weighting scheme, the fund ensures that investors can participate in the growth of major European companies proportionate to their size in the market.

In the forthcoming analysis, we will delve into the intricacies of the iShares Europe ETF. However, I'd like to make it clear that, at this moment, I am not inclined to recommend investing in the [[IEV]] and hence recommend a hold rating for this ETF.

In particular, my aim is to explain why I currently perceive the iShares Europe ETF as too risky for my investment considerations. I will focus on shedding light on the factors that lead me to question Europe's potential for prosperity. By scrutinizing the European economy's landscape, including risk factors such as inflationary pressures and the nuanced monetary policy strategies pursued by the European Central Bank and the Bank of England, I will outline why I find the current climate too precarious to consider wagering on Europe's economic trajectory. Furthermore, I will delve into the ETFs' cost structure, historic performance, and other subtleties to underscore my opinion.

It's important to note that this article is an expression of my personal perspective and opinions. I present this analysis as a tool for readers to evaluate the compatibility of the iShares Europe ETF with their own risk tolerance and investment objectives, given the context I have elucidated.

ETF Details

The iShares Europe ETF has a low-risk profile in terms of volatility, trading at a beta of approximately 0.92, as reported by VettaFi. This characteristic makes it an attractive option for investors seeking stability.

With total assets under management of $1,719.8 million and 33.5 million shares in circulation, the ETF has garnered significant interest from the market.

As for expenses, the iShares Europe ETF boasts a total expense ratio of 0.67%, which isn't necessarily low considering similar ETFs.

Currently, the ETF's price-to-earnings (P/E) ratio stands at 13.67, reflecting a relatively attractive valuation for the underlying European companies within the fund's portfolio.

In terms of liquidity, the iShares Europe ETF sees an average daily volume of $14,442.715, ensuring sufficient trading activity and ease of buying or selling shares.

For income-focused investors, the ETF offers a semiannual dividend payout. At present, the dividend yield amounts to 2.59%, equivalent to $1.30 per share.

In terms of dividend safety, the ETF made a point by paying a dividend consecutively over the past 16 years. Unfortunately, it lags a bit in terms of dividend growth according to figures provided by Seeking Alpha: at a 10-year perspective, the fund has a dividend growth rate of 1.46%, whereas the median reported about 6%, earning iShares Europe ETF merely a D+ rating after Seeking Alpha's rating scheme.

Nevertheless, note that Seeking Alpha includes "All ETFs" in this median figure, so it might not be overly precise.

Holdings and Composition

In terms of holdings and composition, the iShares Europe ETF follows a market cap-weighted scheme, providing investors with exposure to a well-diversified portfolio. The top three positions in the fund include Nestle S.A. (3.16%), ASML Holding NV (2.78%), and Novo Nordisk (2.53%). These leading companies demonstrate the fund's inclination towards established and prominent players in the European market.

IEV 's portfolio boasts a robust level of diversification across various sectors, with its top 15 positions accounting for approximately 27% of the fund's assets. In total, the ETF holds 363 positions.

The fund's focus predominantly revolves around large-cap holdings, with companies possessing a market capitalization above $12.9 billion constituting over 90% of its portfolio. This characteristic positions IEV as an excellent choice for investors seeking European stock market beta exposure, rather than purely aiming to generate alpha through smaller-cap companies.

Taking a closer look at sector allocation, financials assume the largest share, accounting for approximately 16% of the fund's assets. Healthcare and industrial sectors each make up about 15% of the portfolio.

This diverse sector mix enhances the ETF's resilience and ability to capture potential growth opportunities across various industries.

When examining the geographic distribution of iShares Europe ETF's holdings, UK-based companies take the lead with around 22% of the total assets. France follows closely with an 18% allocation, while Switzerland contributes approximately 17%.

This geographical spread offers investors exposure to some of the most influential economies in Europe, enabling them to participate in their respective market dynamics.

Market Overview

In this section, we will take a closer look at the current economic landscape in Europe, with a particular focus on key indicators such as inflation and economic growth. These factors are essential in understanding the future performance and potential implications for the iShares Europe ETF.

Inflation

The eurozone's inflation rate took a step back in July, dropping to 5.3% from the previous month's 5.5%. This decline marks the lowest level of inflation since January 2022, before, among others, the Russian invasion of Ukraine created extended economic uncertainty. Although there is a positive sign of resilience in Europe's economy, the European Central Bank's (ECB) target of 2% remains a distant goal.

Despite some moderation in inflation, certain sectors still face significant challenges. Annual inflation for food, alcohol, and tobacco slightly eased to 10.8% in July, compared to 11.6% in June. On the other hand, energy and industrial goods experienced price declines. The services sector, however, witnessed a slight uptick in inflation, reaching 5.6% in July, up from 5.4% in the previous month.

The ECB has been taking aggressive measures to curb inflationary pressures. Just last week, it raised interest rates for the ninth consecutive time to 425bps, bringing them to their highest level in 23 years.

The central bank is keen on combating inflation; however, the data on core inflation does not inspire confidence that these interest rate hikes are yielding the desired impact.

ECB Chief Christine Lagarde has reiterated that interest rates will continue to rise until there are signs of declining pressures on consumer prices.

The eurozone's inflation situation is multifaceted, with various factors contributing to the persistent surge. High inflation has been influenced by a series of significant shocks, including the COVID pandemic, which resulted in a shift in consumer behavior from services to goods. The shortage of goods due to supply chain disruptions led to higher prices, especially for goods imported from abroad. Russia's invasion of Ukraine also exacerbated the situation by causing large increases in gas prices and driving up food prices further.

For the UK, which is an essential component of the iShares Europe ETF, the Bank of England ((BOE)) has taken a similar approach to address surging inflation. The BOE raised its key interest rate by a quarter point to 525 bps, bringing it to its highest level since 2008.

This is the 14th consecutive rate hike as part of a monetary policy tightening campaign to combat the highest inflation in 40 years, currently at 7.9%, which is even above the European inflation figure, which is derived as an average number from all member states. Although inflation has come down from its peak, it still remains significantly above the BOE's target of 2%.

The inflationary pressures in the UK share similarities with those in Europe. Food prices, in particular, have been a significant driver of inflation, posing challenges for central banks in selecting appropriate measures to address the issue.

Unlike other goods, consumers and households cannot easily reduce their demand for food, as it is a basic necessity for living. Additionally, the surge in energy prices has also played a crucial role in driving inflation in Europe, further complicating the central banks' efforts to control it.

Many of the price increases leading to elevated inflation levels in Europe are driven by external factors that lie beyond the direct control of central banks. As an example, in the US, inflation initially arose due to supply chain constraints but later transitioned into labor market inflation, driven by wage pressures. The US Federal Reserve's ability to steer and control inflation through rate hikes and other measures proved relatively successful, resulting in a decline in inflation. However, in contrast, European inflation remains significantly elevated, indicating the challenges faced by the BOE as well as the European Central Bank (ECB) in managing the situation.

Energy Prices

In recent months, one of the most significant uncertainties and concerns surrounding inflation has centered around energy supply and prices in the wake of Russia's invasion of Ukraine. This geopolitical event prompted European lawmakers to take action, enforcing a ban on further imports of cheap Russian energy, which posed a substantial risk to industries heavily reliant on affordable resources, such as Germany's energy landscape.

The resulting spike in energy prices sent shockwaves through the European economy, raising fears of severe repercussions for various sectors. However, there is some relief on the horizon. As depicted in the gas prices chart below, energy prices across Europe have gradually eased, indicating a return to a semblance of normalcy.

Though prices remain historically high, the overall downward trend brings a degree of optimism for European economies.

One fortuitous factor that contributed to this easing was a mild winter, which came at an opportune moment, as it helped to mitigate the loss of significant volumes of Russian pipeline gas. This, in turn, alleviated some of the demand pressures that had been contributing to soaring energy prices. As Europe exits winter, injection demand is expected to remain relatively muted, as inventories are at elevated levels.

As policymakers and central banks grapple with these dynamics, investors need to be mindful of the potential impact on various sectors, including those represented within the iShares Europe ETF . Moreover, it is crucial to remain attentive to developments in energy prices and supply, as they have far-reaching effects on the broader European economy and could influence the investment landscape.

Implications for European financial institutions

So there are concerns about the effectiveness of aggressive rate hikes as well as their potentially rather threatening implications, particularly on banks, which, by the way, make up a significant stake in the iShares Europe ETF but also sectors other than banks that might be impaired if a recession or any other form of a hard landing is inevitable to bring EU inflation down.

As the ECB takes an aggressive stance in combating eurozone inflation, one major sector that is particularly impacted within the iShares Europe ETF is financials, with a predominant focus on banks.

While rising interest rates are expected to benefit banks in the short term by improving their net interest income, they may also create challenges for their net worth in the medium term. On aggregate, euro area banks exhibit a positive duration gap, which means that if interest rates continue to rise, their assets could lose more value than their liabilities, thereby reducing the economic value of equity. This phenomenon is reflected in the widening of the duration gap since the first quarter of 2021, indicating that banks are facing increased interest rate risk.

As the ECB continues its aggressive stance on interest rates, it becomes crucial for investors to closely monitor the performance of financial institutions within the iShares Europe ETF and assess their ability to manage the challenges posed by the evolving interest rate environment.

Economic Growth/Recession Fears

The economic data from Europe has been a mixed bag, providing both a glimmer of hope and potential risks that may put the performance of the IEV ETF at risk. On the one hand, there have been recent positive growth numbers within the Eurozone, offering a little light in the dark times of economic uncertainty. Eurostat revealed that the eurozone's economy grew by 0.3% in the second quarter of 2023, surpassing previous projections. Moreover, GDP was up 0.6% compared to the same period last year. Within the euro area, there have been notable disparities in growth rates. Ireland recorded the highest quarter-on-quarter increase at 3.3% while Germany, often considered the economic powerhouse of the union, managed to eke out a meager 0.0% growth.

The months leading up to this growth report were characterized by stagnant GDP across the euro area, with high borrowing costs stifling economic expansion. While the figures released provide hope that the eurozone could achieve the ECB's forecast of 0.9% growth for the year, the overall economic landscape remains fragile.

One significant indicator that demands attention when assessing the possibility of a recession is the inversion of the yield curve. The euro area yield curve, as depicted in the image below, has shown a clear inversion.

An inverted yield curve has negative implications and reflects investors' concerns about potential economic challenges on the horizon. While it is not an absolute predictor of a recession, it serves as a warning sign that investors perceive elevated risks.

Unlike the US Federal Reserve, which appears to have concluded its rate-hiking cycle, it is likely that the ECB and BOE will continue to raise rates, leading to even tighter financial conditions for businesses in particular. This trajectory could increase the likelihood of a recession as it becomes more challenging for businesses to access credit and invest in growth initiatives.

While the US Federal Reserve seems to have achieved a soft landing by effectively managing inflation without causing significant damage to the overall economy, the European economies, including the UK, face more complex challenges. The issues surrounding inflation and tight financial conditions in Europe and the UK may make achieving a soft landing a more formidable task.

Performance

Turning our attention to the performance of the iShares Europe ETF , the fund has demonstrated a notable recovery from its lows, starting in October 2022. As of August 4, 2023, IEV ETF showed a positive year-to-date (YTD) return of 9.42% (SEE IMAGE). While this growth is certainly commendable, it's essential to put it into perspective by comparing it to other Eurozone ETFs.

For instance, a casual Euro Stoxx ETF like FEZ has performed slightly better, boasting a YTD return above 15%. Similarly, the German Dax ETF DAX has shown an impressive 13% YTD return. In contrast, the US stock market, represented by the S&P 500 and the renowned SPY ETF, has outperformed with a remarkable 17.33% YTD return (all price data as of August 4, 2023, at market close).

Examining fund flows, it's worth noting that they turned positive at the beginning of 2023. This positive trend can likely be attributed to the easing of EU energy prices, which occurred after the extraordinary peak in 2022 due to the Russian invasion of Ukraine and the subsequent embargo on Russian energy imports. However, more recently, fund flows have turned negative again, potentially due to a combination of factors highlighted in the Market Overview section.

Tax Structure

The following is data provided by iShares:

Max ST Capital Gains Rate: 39.60% This refers to the maximum short-term capital gains tax rate that US investors may be subject to when they sell the ETF shares within a year of purchase.

Max LT Capital Gains Rate: 20.00% On the other hand, this refers to the maximum long-term capital gains tax rate that US investors may face when selling the ETF shares after holding them for more than a year.

Tax On Distributions: Qualified Dividends The ETF's distributions to investors are qualified dividends, which means they are taxed at the long-term capital gains tax rate rather than the higher ordinary income tax rate. This can be advantageous for investors, as it allows them to enjoy a lower tax rate on the income generated by the ETF's holdings.

Furthermore, the absence of K-1 distributions simplifies the tax reporting process for investors, making it easier for them to manage their tax obligations.

Conclusion/Opinion

In my opinion, I would not recommend buying the iShares Europe ETF at this time. While I wouldn't necessarily advise selling it if you already own it, there are several reasons why I am concerned.

Firstly, the uncertainties surrounding the European economy, particularly in the face of inflation and aggressive monetary policies, are significant factors to consider. The ongoing challenges with high inflation rates and the actions taken by the European Central Bank (ECB) and the Bank of England ((BOE)) to combat these pressures may impact the performance of European markets and, consequently, the iShares Europe ETF.

Secondly, the cost structure of the ETF is a notable drawback. With a relatively high expense ratio compared to some of its competitors, the fund's fees could erode potential returns over time.

Furthermore, while the ETF offers decent liquidity and diversification, there are other quality aspects that do not stand out. For instance, the fund's performance, while showing signs of recovery, lags behind some other European and US market benchmarks. This may raise concerns about the opportunity costs for investors seeking higher returns.

In light of these factors, my opinion is that investors should exercise caution when considering the iShares Europe ETF as an investment option. In light of the economic landscape and headwinds ahead, you might turn back to Europe when there is more clarity. Moreover, if I were to buy an ETF offering European market exposure, I would personally explore alternative ETFs for more cost efficiency.

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