EWA: With U.S. Stocks Above Their Pre-Crisis Levels, It May Be Time To Consider Oz (NYSEARCA:EWA)

Main Thesis

The purpose of this article is to evaluate the iShares MSCI Australia ETF (EWA) as an investment option at its current market price. I have held a neutral outlook on EWA for all of 2020, but I believe the risk-reward balance has shifted going forward. With the broad U.S. indices looking less tempting to me, diversifying overseas makes a good deal of sense. With EWA lagging so far this year, the fund offers a steep discount to the S&P 500, as well as a higher dividend yield. Further, the Australian government is pushing forward measures designed to increase the flow of credit, which should be a short-term positive for households, businesses, and lenders. Finally, the labor market has seen a decrease in unemployment and an increase in labor force participation, both of which are great signs for overall economic health.

Background

First, a little background on EWA. The fund is managed by BlackRock (BLK), and its objective is to “track the investment results of an index composed of Australian equities”. Currently, EWA trades at $19.86/share and yields 3.73% annually, paying semi-annual distributions. I covered EWA back in June as the market was stabilizing and placed a neutral rating on the fund. While I saw limited downside, I saw little chance of the fund outperforming U.S. equities, and therefore did not view it as a worthwhile way to diversify. In hindsight, this outlook was spot on. While EWA has offered a positive return, it is about one-third the return from U.S. stocks during the same time period:

Source: Seeking Alpha

As I look ahead to 2021, I see limited value in the broader U.S. market. Therefore, I am focusing on relative value, as well as diversification. With my gold and fixed-income positions built up, I see merit to branching out overseas to hedge against short-term volatility here at home. As a result, I believe EWA is a decent buy candidate at the moment, and I will explain why below.

Australia’s Index Has Been Lagging The U.S.

To begin, I want to reiterate that EWA is more of a relative play right now, rather than an outright screaming buy. In fairness, I do see some positives within the Australian economy, which I will get to later in this review. However, the country has been impacted by the Covid-19 crisis just like the rest of the developed world, and has officially entered a recession. This was a significant development, albeit predictable, because Australia has had a 30-year ride without a recession. It was one of the few developed economies that did not see a recession during the 2008-09 financial crisis, as shown below:

Source: ABC News

My point here is that Australia has its challenges right now, but the good news for investors is the challenges seem to be priced into stocks, more so than their U.S. counterparts. To see what I mean, let us consider 2020 performance of EWA against the S&P 500 ETF Trust (SPY), shown below:

Source: CNBC

As you can see, both the U.S. and Australian stock markets suffered greatly during the February-March sell-off. However, unlike the U.S., the broader Australian market has not recovered in entirety. While U.S. stocks now sit in positive territory for the year, EWA is still looking at a double-digit loss.

Now, it could be fair to view this performance gap as a reason to avoid EWA, and to favor U.S. stocks, which have proved more resilient in the face of Covid-19 pressures. However, I would caution against this logic for the time being for a few reasons. One, I view U.S. stocks as overpriced, as they are now sitting higher than pre-February levels, yet the broader economy is nowhere near as robust as it was back then. Two, the Australian economy is also embarking on stimulus measures to help households and businesses recover. Seeing the success the U.S. has had post-stimulus announcements, I feel there is upside left for Australian stocks if investors see the government’s actions as making meaningful progress. Three, I expect forthcoming volatility in U.S. markets due to the upcoming presidential election, and Australia does not face this headwind in the immediate term.

Essentially, it comes down to relative value, as I see limited upside left for U.S. stocks, and more upside potential “down under”. To highlight why, let us consider the current P/Es of both EWA and SPY, along with the current dividend yields, as shown below:

Fund P/E Ratio Current Yield
EWA 17 3.73%
SPY 24 1.60%

Source: iShares; State Street

My overall takeaway is the risk-reward picture seems a bit more favorable for EWA right now. While I tend to favor U.S. stocks over the longer term, I am hesitant to add to positions right now given the presently high levels. With EWA trading at a nice discount to the S&P, along with offering a higher dividend stream, there is merit to giving this fund some consideration.

Australia’s Employment Picture Is Improving

I now want to shift to some reasons why I believe Australia may see brighter days ahead. As noted above, the economy now faces a recession, and the broader Australian index has lagged its American counterpart. Therefore, it stands to reason investors may question why they would want this exposure. EWA has not been a winning investment this year, and there are justifiable reasons why it could continue to fall behind SPY going forward as well.

Despite my reservations about Australian equities, I see a few reasons for optimism. One in particular is the improving labor market. While the country is still far from its pre-crisis levels, there has been marked improvement over the past few months. In fact, the unemployment rate has dropped to 6.8%, while labor participation has spiked higher, as seen below:

Source: Bloomberg

I view this positively. Yes, there is a ways to go still, but it tells me the worst of the crisis is over, similar to the U.S. story. People are going back to work, and the ranks of the unemployed are finally starting to reverse. This should improve the consumer spending picture and limit bad debts going forward. Is Australia on a path to amazing economic figures? Probably not. But unlike the U.S., where stocks seem to be ignoring the downside potential, Australian equities seem to be downplaying the positive developments. This is a signal to me to put the contrarian hat on, and give Australian equities a chance.

India May Help Ease The China Fallout

My next point has a more mixed picture. I spent a good deal of time in my last review highlighting the geopolitical risks between the Australian and Chinese governments. While the Chinese are inter-linked with American and European economies as well, Australia’s proximity to China, and lack of proximity to the rest of the developed world, make its reliance on the China more important. Australia is heavily reliant on China for exports, tourism, and students (in higher education), and I discussed in great length how fallout from the Covid-19 crisis could put this important relationship at risk.

Looking forward, I continue to see this as a risk, but I also want to point out there are ways for Australia to limit the downside potential. First and foremost, I see a de-coupling with China as very unlikely in the near term. There is certainly a growing sense of animosity between the two governments, but the fact is it will be increasingly difficult to shift supply chains anytime soon. Further, the economic realities of what this might do to the Australian economy may result in anti-China political rhetoric, but not much else. Simply, as the pandemic fades, I think the appetite for holding China accountable will wane, and the negative economic potential could stall progress on this front.

To be clear, my outlook is that the Chinese relationship will pose a significant headwind for Australia, both politically and economically. However, I think Australian equity levels reflect this uncertainty. Furthermore, Australia does have some options on the table when it comes to mitigating the fallout out of Chinese trade relationship. With America, Europe, and Australia all presently looking for options outside China, a number of countries are hoping to reap the rewards. South Korea, Vietnam, and, perhaps mostly importantly, India, are all nations hoping to grab a slice of the pie that China could potentially lose.

Fortunately for Australia, the trade partnership with India had already been growing leading into 2020. Of course, without question, China is the largest and most important trading partner for Australia. But if Australia is looking to shift some of its reliance and/or supply chain over to India, the transition may be smoother than expected. In fact, the value of Australian exports to India has been consistently rising since 2013, as shown below:

Source: Bloomberg

My takeaway here is not to ignore the headline risk of souring China-Aussie relations. This is a very large headwind, which is why I discussed it at great length back in June. However, given the lackluster performance of Australian equities, I believe the market has been pricing in this headwind, opening up a better buying opportunity. Given that the country has been growing its relationship with India, this is a very real option for balancing out some of its reliance on China in the near term.

Financials Get A Short-Term Win

My final point touches on a development in the Financials sector, specific to Australia. This is always an important area to focus on when considering an investment in EWA, as it is the largest sector by weighting in the fund, as it has been for some time. In fact, Financials currently make up over 30% of total fund assets, as shown below:

Source: iShares

This has been a sore spot for the fund for some time, as a banking inquiry, lack of public trust, growing bad debts, and low interest rates have all made it difficult for Australian bank stocks over the past year. However, the sector recently got a boost at the end of September, with the Treasurer of the Commonwealth of Australia, Josh Frydenberg, announcing measures to expand the access to credit and small businesses. Specifically, a key measure is:

Allowing lenders to rely on the information provided by borrowers, replacing the current practice of ‘lender beware’ with a ‘borrower responsibility’ principle” – Source: Australian Treasury

What this means is, the onus of responsibility for determining the suitability of a loan will be shifted to the borrower instead of the bank. The reason given for this measure is to correct what they see as a restrictive credit environment, by reducing the burden on banks when it comes to making loans.

Now, I should point out I am not enthusiastic about this measure in principle, especially for the long-term health of the sector. Not verifying income or financial disclosures is probably not in the best interest of the bank when it comes to making loans. In fact, this was a key tenement that helped contribute to the U.S. financial crisis. Yet, in the short term, this is a win for the banks. It will reduce regulatory and compliance costs and should improve profits initially as more loans are made. Additionally, it should also make loan approval times faster, improving the impact of lending to small businesses.

While these measures do not officially go into effect until March 2021, the market’s initial reaction has been receptive. If we look at the share price performance of Australia “Big 4”, Westpac Banking Corporation (NYSE:WBK), Australia and New Zealand Banking Group Limited (OTCPK:ANZBY), Commonwealth Bank of Australia (OTCPK:CBAUF), and National Australia Bank Limited (OTCPK:NABZY), all of which are top 10 holdings within EWA’s portfolio, we see their shares initially soared on the news that came out in late September:

Source: CNBC

Therefore, it is fair to say this headline is being viewed positively for now, and that it could be a short-term tailwind for EWA. Again, I think the longer-term implications of this measure will not be positive, but for investors with a short-term horizon, this could help them profit off Australia’s rebound.

However, aside from my general attitude about the merit behind this proposal, I must also caution investors that the Financials sector within Australia is facing a difficult climate. While this move could help lending profits, overall earnings among Australia’s largest banks are down significantly in 2020 year over year. In fact, analysts do not expect bank earnings to recover to pre-crisis levels in 2021 either, as shown below:

Source: Hamilton

My conclusion is I see some positive tailwinds for the banking sector, including fewer regulations and improving profits. But I must manage expectations by noting the sector is struggling, and these small measures will not be enough by themselves to get back to normal. The country, and economy as a whole, are going to have to markedly improve in order for the long-term health of Financials to truly excite me.

Bottom-line

EWA has lagged the U.S. market, but I see merit to diversifying “down under” right now. U.S. stocks appear too pricey for my blood, and Australia continues to pump stimulus dollars and enact expansionary measures to lift the economy. With the banking sector rallying on some positive news, the employment picture improving, and the country looking to seize on the already growing trade relationship with India, I see better times ahead for Oz. Thus, I am considering a position in EWA, and recommend investors give the fund a serious look at this time.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in EWA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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