EWA - iShares MSCI Australia ETF: A Worthy Portfolio Addition

Summary

• The iShares MSCI Australia ETF offers investors a low-cost vehicle to access Australian large and mid-cap equities.
• In addition to the income appeal, the ETF is poised to benefit from commodities-driven global tailwinds and a more resilient domestic economy in the near term.
• Relative to the growth prospects and the quality of the portfolio, the earnings valuation screens fairly.

Australia has long been viewed as a stable income rather than a growth-focused market, but this year's equity performance, as reflected by the iShares MSCI Australia ETF's ( EWA ) outperformance, has defied prevailing investor perceptions. A key reason for the YTD rally is the outsized exposure to financials, which continues to be supported by a hawkish central bank (the Reserve Bank of Australia or 'RBA'). This month's economic data will only give the RBA ammunition for more hikes, with all signs pointing to a still very tight labor market and accelerating services inflation. Elsewhere, the materials exposure (the ETF's second-largest sector allocation) has also benefited from an upswing in commodities and, via the sector's USD-denominated market exposure, offers a hedge against the AUD across the rest of the portfolio. The valuation has re-rated to ~14x PE, but the high ~6% yield and unique exposure to a commodities-driven Australian economy make this ETF a worthy portfolio addition for the mid to long-term.

Fund Overview - A Low-Cost Vehicle for Australian Exposure

The iShares MSCI Australia ETF tracks, before fees, the performance of the MSCI Australia Index , a market cap-weighted index comprising Australian large and mid-cap equities. In aggregate, the index covers ~85% of the free float-adjusted market cap in Australia. The ETF is available to investors via two options – the iShares MSCI Australia ETF in USD for US and non-Australian investors and the iShares Core S&P/ASX 200 ETF in AUD for Australian investors. The ETF held >$2bn of net assets at the time of writing and charges a 0.5% expense ratio, making it a cost-effective option for US investors looking to access Australian equities.

As reflected in the graphic below, the fund's sector allocation skews toward the financials (32.7%), materials (26.0%), and healthcare (10.3%) sectors, which account for a combined 68.9% of the total portfolio. The fund's largest holdings are multinational mining, metals, natural gas petroleum company BHP Group ( BHP ) (14.1%), financial services leader Commonwealth Bank of Australia ( CBAUF ) (10.4%), biotech company CSL ( CSLLY ) (8.0%), and National Australia Bank ( NABZY ) (5.6%).

On a YTD basis, the ETF has returned 13.5% and has appreciated significantly in value since its inception in 1996 at >7% annualized, in line with its benchmark. Income distributions are paid out on a semi-annual basis. Thus far, the fund has distributed $1.17/share for 2022 out of income (implied mid-single-digits % yield). While the FY21/FY22 distributions were higher than usual, helped by the fund's exposure to mining and energy, Australian equities tend to pay high, well-covered dividend yields, so future distributions should remain strong.

Latest Economic Releases Point to More Hawkishness

The latest headline inflation data in Q4 saw a 1.9% QoQ increase, below the RBA's implied headline forecast from its November monetary policy statement of ~2% QoQ but above the 1.5% QoQ trimmed mean (i.e., adjusted for outliers). Digging deeper into the data, the inflationary uplift was broad-based across categories, led by annual goods inflation coming in at +9.5% YoY. While this was still ahead of services, the +5.5% YoY increase in services inflation represents a worrying acceleration at +2.1% QoQ. This comes as a surprise given the softer December employment report , with employment growth down by ~15k in December, albeit due to declining part-time employment (-32.2k) rather than full-time jobs (+17.6k).

With inflation showing no sign of slowing down (even making new highs in YoY terms), the risk of a rise in inflation expectations will weigh heavily on the RBA's decision-making. The key to slowing down inflation lies in loosening the labor market, which remains tight amid continued worker shortages and historically low unemployment rates. In that sense, the runway back to the RBA's 2-3% inflation target is long, particularly with most measures still annualizing in the high-single-digits % and services inflation picking up. Pending the RBA's modeled neutral rate estimate moving back into slowing or restrictive territory, I would continue to pencil in more hikes this year.

Well-Positioned to Capitalize on More Rate Hikes

Rate hikes are typically bearish for valuations – Fed hikes last year, for instance, saw valuation multiples contract across the board. The iShares MSCI Australia ETF's exposure to financials (its biggest sector allocation) means it will continue to benefit, as higher rates typically allow for more net interest margin expansion. This will need to be weighed against recent data indicating a decline in the total value of new housing loan approvals (now well below the early 2022 peak) and, by extension, a softer outlook for housing credit growth in the coming quarters.

In volume terms, however, the decline in number of approvals for owner-occupiers for established dwellings decelerated MoM, offering hope of resilient transaction activity in the face of weaker property values. Also worth considering is the rebound in Australian consumer sentiment at +3.0% MoM in December per the Westpac Melbourne Institute survey, reversing from a weak November print. While the survey indicates consumers aren't yet in great shape, the key bright spot was the improved expectations of house price gains going forward, which bodes well for credit activity. Further, respondents appear to have revised down expectations for future interest rate hikes, potentially indicating more consumer credit growth on the horizon. All in all, the prospect of a more resilient domestic economy, in addition to the global growth tailwinds post-China reopening, creates a compelling near-term setup for the ETF.

A Worthy Portfolio Addition

Investors looking to gain low-cost exposure to Australia will want to consider the iShares MSCI Australia ETF. In the near to mid-term, the setup is compelling, given the fund's sectoral exposure to financials, which is being supported by a hawkish central bank. If recent job and inflation data points are anything to go by, the RBA is nowhere near the end of its tightening cycle – the labor market remains strong, with the unemployment rate well below trend, and services inflation is showing signs of accelerating. Beyond the outsized banking exposure, the fund's large materials weighting also allows it to benefit from an increasingly bullish outlook for commodities in the coming years. The valuation isn't that cheap at ~14x trailing earnings, but the high-single-digits % yield helps, along with the prospect of a structurally more bullish commodities-driven outlook for the Australian economy.

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