VEA - iShares MSCI United Kingdom Small-Cap ETF: A Mixed Bag

2023-04-05 15:57:44 ET

Summary

• iShares MSCI United Kingdom Small-Cap ETF covers over 250 small-cap UK stocks.
• EWUS is well exposed to industrials that are currently struggling with margin challenges.
• EWUS offers good earnings potential for its valuation, and it also looks oversold relative to large-and-mid-cap British stocks.

While it may seem small, the ripple effects of small things are extraordinary. - Matt Bevin.

In last week's "Leaders-Laggards" section of The Lead-Lag Report, I noted how a few conditions are in place to bring through short-term outperformance in foreign equities. If you're on the lookout for suitable opportunities in this vast space, you may consider looking at the iShares MSCI United Kingdom Small-Cap ETF (EWUS), a portfolio that offers targeted exposure to around 250 small public companies in the UK. However, before you jump into EWUS, here are a few important factors to consider.

What To Consider

Investigative journalist- Christopher Leonard, who was a recent guest on the Lead-Lag Live channel , was very keen to reiterate that economic conditions in the periods ahead are likely to be very volatile, thus potentially catching a lot of investors off guard. It's fair to say that the UK may well be one of those chief flagbearers of economic uncertainty

After three straight months of declines, many thought that high inflation in the UK was on its way out, but a couple of weeks back, the CPI reading for Feb came in at an elevated figure of 10.4%, up from 10.1% seen in Jan; crucially, it was a good 50bps higher than what a Refinitiv poll was expecting.

Consequently, even though there were a few rumblings of the contagion effect from the U.S. banking crisis, the Bank of England ((BOE)) was left with limited choice but to hike policy rates by 25bps yet again to 4.25%. Relentless rate hikes have left a mark across different segments of the economy with Q1-23 GDP likely to have contracted by 0.1% . Investors also need to consider that the UK will have its work cut out, as amongst all the G7 economies, it is the only economy where economic output still remains below the pre-pandemic level of 2019.

Worryingly, looking ahead, the UK could also be the only G7 economy that may witness real GDP decline (of 0.2%) for the whole year.

If you drill down even further, there are plenty of cogs within the UK economy that still remain quite hamstrung. Deutsche Bank noted that both the level of household consumption and business investment are still around 200bps lower than what it was in the final quarter of 2019. Meanwhile, UK export volumes too are 150bps lower than the pre-pandemic range.

Weak export-related sentiment could weigh heavily on EWUS's prospects as industrials account for the largest share of the portfolio. The manufacturing PMIs have proven to be yet another volatile metric with the recent March figure dropping to 47.9, after Feb's reading hit 7-month highs of 49.3. The PMI report also noted that small-sized manufacturers in particular were struggling with lower output.

One area to track will be the trajectory of input prices which still remain in double-digits and are hampering margin expansion. The image below shows that UK manufacturers have been able to push through higher prices but the PPI figure was still growing at 14%. Of course, it's come a long way from the 24% levels seen in mid-2022 but we would still need this to come down even more for margins to start trending up.

The competitiveness of UK exports could also be impacted by the strength of the GBP. The relentless rate hikes by the BoE have only bolstered the allure of British assets, sending the GBP/USD pair beyond a crucial resistance point of 1.25. I don't believe we are in any position to expect a ceiling with rate hikes, as the UK finance minister has been on record stating that the current administration's "first priority is to halve inflation." A halving of inflation will require more than just a strong base effect. All in all, things look good for the pound more so when you consider the sub-optimal conditions for the dollar.

Conclusion

While investors would do well not to be too expectant of sanguine progress from the UK economy going forward, there are still quite a few encouraging themes that raise EWUS's allure.

Firstly, one ought to consider the superior earnings growth you'd be getting; YCharts expects EWUS's holdings to deliver solid long-term earnings growth of 11.26% , around 130bps higher than what you'd get from the Vanguard FTSE Developed Markets Index Fund ETF Shares (VEA). Interestingly enough, despite a better earnings outlook, EWUS trades at a lower forward P/E (12.04) than VEA (12.64x).

Besides, even if you look at how UK small-caps are positioned relative to their large-and-mid-cap counterparts we can see that things look quite overextended to the downside, and one may see a reversal back to the long-term trading range.

However, if you've followed my recent commentary on the timeline of The Lead-Lag Report, you'd also be aware that I've been suggesting that April this year could be a difficult month for risk assets. Investors would be better served keeping their seat belts on, particularly when you're dealing with a small-cap high beta segment such as iShares MSCI United Kingdom Small-Cap ETF (5 Yr Beta of 1.39x ).

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