NORW - NORW: Emerging Domestic And External Headwinds Weigh On The Norwegian Outlook

2023-04-02 04:30:55 ET

Summary

• The Global X MSCI Norway ETF continues to be weighed down by the global energy and commodities weakness.
• Domestically, further rate hikes by the hawkish Norges Bank look set to trigger a broader economic slowdown.
• With incremental downside risks from the NOK as well, the near-term setup for Norwegian equities isn't compelling.

Headline inflation in Norway has been reversing lower in recent months, though core inflation has been stickier than expected, pushing the Norwegian central bank ('Norges Bank') to hike by another 25bps at its latest policy meeting. The persistent domestically produced goods inflation is the key concern (in contrast with cooling imported inflationary pressures) and likely entails an extended rate hike runway through the year despite leading indicators already pointing to a broader economic downturn. While not quite as bad as Sweden (see my coverage of the iShares MSCI Sweden ETF ( EWD ) here ), the vulnerability of the Norwegian housing market is an incremental concern following last year's steep declines and the outsized share of variable rate funding. Externally, Norway is an economy highly levered to energy as well, so a weaker global growth outlook this year could weigh on its terms of trade and FX. While the Global X MSCI Norway ETF ( NORW ) portfolio valuation screens reasonably at ~9x P/E for a high-quality portfolio of large caps, I would remain neutral here.

Fund Overview - Low-Cost Exposure to Norwegian Equities

The US-listed Global X MSCI Norway ETF seeks to track, before expenses, the yield and price performance of the MSCI Norway IMI 25/50 Index, which comprises large, mid, and small-cap Norwegian equities (~99% of the free float-adjusted market cap). The ETF held ~$73m of net assets at the time of writing and charged a 0.5% expense ratio, making it a cost-effective option for US investors looking to access Norwegian equities. A summary of key facts about the ETF is listed in the graphic below:

The fund is spread across 70 holdings, with the largest sector allocation going to Energy at 31.4%, followed by Financials at 20.1% and Materials at 12.7%. Of note, the fund has relatively limited exposure to the consumer, with a combined staples and discretionary allocation of ~13%. On a cumulative basis, the top five sectors accounted for ~87% of the total portfolio, making NORW a relatively concentrated single-country ETF from a sector perspective. In line with the energy-heavy exposure, the fund's equity beta reflects the cyclicality of the portfolio at an elevated 1.29 to the S&P 500 ( SPY ) and 1.36 to the MSCI EAFE ( EFA ), which tracks developed markets ex-North America.

The single-stock allocation reflects the energy-focused Norwegian economy, with the fund's largest holding being state-owned energy company Equinor ASA ( EQNR ) at 16.9% of net assets. Other key energy holdings include Norwegian aluminum and renewable energy company Norsk Hydro ( OTCQX:NHYDY ) at 6.3% and oil exploration and development company Aker BP ASA ( OTCQX:AKRBF ) at 4.8% of the portfolio. Leading the financials exposure is Norway's financial services leader DNB Bank ASA ( OTCPK:DNBBY ), at 10.5%, while the 5.1% holding in majority state-owned telecom Telenor ASA ( OTCPK:TELNF ) rounds up the top five. In total, the five largest holdings contribute ~46% of the overall portfolio, making NORW one of the more top-heavy Nordic ETFs.

The fund's underlying earnings and book value multiples of 9.1x and 1.6x, respectively, seem reasonable at first glance, particularly relative to the 18.1% return on equity profile. But context is important – as the NORW portfolio is levered to cyclical sectors like energy and materials, the denominator (i.e., trailing earnings) tend to be elevated in an upcycle, optically lowering valuation multiples. With the price environment set to turn a lot more challenging for energy and commodities globally in the coming months, cyclically lower forward earnings imply higher valuation multiples than displayed here.

Fund Performance – Cyclical Yield, Less-Than-Stellar Track Record of Capital Appreciation

On a YTD basis, the ETF has declined by 2.6% and has compounded at an unimpressive 1.9% rate in market price and NAV terms since its inception in 2010. Given the fund's exposure to cyclical sectors, performance has been volatile - last year saw a low-teens % drawdown amid energy price declines, retracing most of the fund's post-COVID outperformance. On a three, five, and ten-year basis, NORW has annualized at 2.1%, 2.0%, and 1.5%, respectively.

The semi-annual distribution is derived entirely from income, with the fund's holdings in cash-generative sectors like financials, energy, and materials supporting much of the capital return. At a trailing yield of 2.9%, NORW is one of the higher-yielding Nordic ETFs, though the income is subject to cyclical trends and will fluctuate in line with the cycles. Case in point – the fund's 2018 peak distribution of $1.13/share was followed by multiple years of declines to a low of $0.55/share before recovering to $1.03/share in 2022 amid a cyclical upswing in energy prices.

The Norwegian Rate Hike Cycle Isn't Over Yet

The latest 25bps rate hike by the Norges Bank was largely within expectations, reinforcing its commitment to taming core inflationary pressures. The more surprising takeaway from the March policy meeting was the hawkish Norges rate forecast, which now calls for a 3.6% peak in Q4 2023 amid resilient domestic demand and FX weakness. While this view is supported by the official GDP growth print, policymaking tends to work with a lag. Thus far, leading indicators such as the headline PMI measure have already moved into contractionary territory. Consumer confidence has also hit record lows and doesn't appear to be recovering anytime soon. Given the mounting evidence that steep growth declines are on the horizon, an extended tightening cycle doesn't bode well for the near-term earnings outlook.

As NORW investors are also exposed to the NOK (Norwegian Krone), the FX trend should also be a key consideration. On the one hand, the Norges Bank's hawkish stance should offer support to the underperforming NOK. That said, the key drivers of 'commodity currencies' like NOK are external. So with all signs pointing to weaker global growth and energy prices this year, it's hard to see the NOK escaping terms-of-trade pressures. The Norges Bank's efforts to drive FX appreciation via rates should offer some cushion in the meantime, but its runway will likely be limited by domestic weakness later this year as the impact of tightening filters through to the broader economy.

Keep an Eye on Housing

Serious concerns about the state of the Norwegian housing market emerged last year, following consecutive months of price declines toward year-end. House prices have proved more resilient than expected this year, however, helped by fiscal support in the form of loosened mortgage loan terms, as well as an improved macroeconomic picture for the Norwegian economy. Depending on the growth path of employment and wages in the coming months, the housing bulls could well be proven right.

Yet, a more hawkish Norges Bank and leading indicators pointing to a general slowdown in the economy present downside to the Norwegian housing market. With peak rates likely to be raised at upcoming policy meetings as well, expect incremental pressure on house prices, particularly via the mostly variable rate mortgage channel.

Emerging Domestic and External Headwinds Weigh on the Norwegian Outlook

The latest round of hikes by the Norges Bank reaffirms its focus on price stability over growth, with 'sticky' domestic inflation remaining top of mind despite cooling imported price pressures. While official GDP and employment data points support the case for an extended rate hike runway, leading indicators are starting to signal emerging risks to the growth trajectory. The Norwegian housing market is another risk to keep an eye on – house prices have already seen protracted declines over the last year and could decline further, given a significant % of Norway's mortgage rates are variable. Beyond the domestic headwinds, a weaker external environment this year also presents a key pressure point, particularly through the energy channel. Net, the near-term setup isn't compelling for NORW here, and I would remain in 'wait-and-see' mode.

For further details see: