EWU: I Was Much Too Optimistic, Uncertainty To Remain A Headwind

Summary

• EWU, the iShares MSCI United Kingdom ETF, has been caught up in the recent sell-off, and it has seen a drop close to 15% since my last review.
• With ongoing political uncertainty surrounding Brexit, EWU is not for the faint of heart. However, British equities do remain attractively priced compared to their European counterparts.
• UK retail sales surpassed expectations in January. Similarly, business confidence is up since the Tory election win. However, these developments could falter if trade progress is not made.

Main Thesis

The purpose of this article is to evaluate the iShares MSCI United Kingdom ETF (NYSEARCA:EWU) as an investment option at its current market price. While I was optimistic on British equities heading in to 2020, EWU has been under pressure since mid-January.

The recent election provided some clarity on Brexit, but negotiations continue to make little substantive progress, and that is clouding the outlook for what a post-Brexit United Kingdom will look like. Fortunately, optimism among consumers and businesses remains relatively high. This has supported surprisingly strong retail figures and a positive outlook for business investment. However, continued uncertainty is likely to cap this momentum going forward. While British stocks do appear cheap, compared to their U.S. and European counterparts, I see the chances of out-performance as quite slim as we move deeper in to the year.

Background

First, a little about EWU. The fund's stated objective is "to track the investment results of an index composed of U.K. equities." The fund only offers exposure to large and mid-sized companies that are based in the United Kingdom. EWU is currently trading at $28.94/share and yields 4.87% annually. Looking back on my coverage of EWU, I recommended getting in to the fund late last year, and that trade generated some alpha in the short-term. However, I reiterated a bullish stance as 2020 got underway, as I saw the Tory victory in December elections as a tailwind for British equities. This call proved incorrect, as EWU has seen more than its share of selling since the market correction got underway, as shown below:

Source: Seeking Alpha

Given this sharp drop, I wanted to give an updated review of EWU, and discuss where my thinking erred in January. After review, while some may see the broad market's decline as a buying opportunity, and I would as well, I am shirting to a more neutral stance on EWU individually. While I believe the fund could push higher going forward, I see little chance of British equities out-performing the S&P 500 in the short-term, and believe uncertainty surrounding Brexit will continue to weigh on the fund.

The Good: British Equities Remain Cheap

To start, I want to begin with a primary reason why investors may consider looking at British equities. Specifically, this relates to the relative cheapness of equity prices in the U.K., compared to the rest of the world. In fairness, this has been the case for some time, and funds like EWU have been lagging other broad-based funds. However, with equity markets seeing a high level of turmoil right now, I believe it is an opportune time to really look for value. Simply, if value options are starting to pique investor interest, that is going to lead them to the U.K.

To see why, consider the cost to own a broad basket of British equities, compared to the rest of the world, as measured by P/E ratios. According to data compiled by Bloomberg, the broad U.K. index is trading at a 20% discount to the rest of the world, as shown in the graph below:

Source: Bloomberg

As you can see, this is a marked discount, and it is especially notable as it has reached a level not seen since 2010.

My takeaway here is simple, British equities appear very reasonably priced on a relative basis. With uncertainty regarding global growth putting investors on edge, an index trading at a marked discount to the world could look especially attractive. Considering EWU offers exclusive exposure to large and mid-cap British companies, this valuation story remains a positive for the fund.

The Good: Retail Sales Have Been On The Rise

My next point also offers a positive slant. While U.K. retail sales were sluggish for most of 2019, the new year has started on a bit of a high note. In fact, total retail sales increased 1.6% for the month of January, which was the best reading in almost two years, as shown below:

Source: Bloomberg

As you can see, this is a pretty good reading, and it has come at a welcome time. After the December election, business and consumer confidence rose, and it turns out some of that confidence translated in to actual sales.

Of course, the December win for the Tories was certainly not the sole reason for an uptick in retail. One especially important area that has kept the British economy from tipping in to a recession has been the resilient labor market. Despite the uncertainty created by the Brexit vote, employment figures have actually improved since the vote was held in 2016. With the unemployment rate consistently dropping, the current figure is at a generational low:

Source: Deloitte

My takeaway here is that these stories, increasing retail sales and low unemployment, should provide some downside protection for British equities. Both of these metrics tell of a generally strong consumer, all things considered. With equities already at cheap prices, continued strength in the consumer retail sector should be a modest tailwind going forward.

Business Confidence Rose, But Investment Is Subdued

My next points have a more cautious outlook, and concern the general state of the British economy. As I noted in my prior review, investors and business leaders generally cheered the December election outcome. The result gave the Conservative Party a clear majority, and also helped remove some of the uncertainty regarding Brexit. While plenty of uncertainty still exists, it ended the constant back and forth between the Prime Minister and the Labour Party. With the Conservatives in full control, Brexit became the reality. Of course, this still left the major details of trade to be determined, but, ultimately, the U.K. officially exited the European Union, which was a development that had been in-progress for over three years.

Looking back, the initial reaction to the election was positive in the business community. In fact, confidence broadly soared in C-suites, according to a survey conducted by Deloitte, with the results shown in the graph below:

Source: Deloitte

Clearly, this was a positive sign, and investors were hopeful readings like this would result in increased business investment and activity.

While increased confidence is good news, it is only half the story. The other half is actual results, and those have not materialized as of yet. While new investment may indeed pick up in the short-term, recent history shows a lot of weakness in this area. Specifically, business investment growth has been negative in five out of eight quarters in the last two years, including a sharp drop in Q4 last year, as shown below:

Source: Bloomberg

My takeaway here is betting now on the backdrop of higher optimism levels is not a sure thing. While there may certainly be increased investment in the short-term, recent figures have been quite weak. Therefore, if we see only a modest increase in the first few quarters this year, it will not make up for the lack of investment we have seen over the past three to four years post-Brexit. Simply, the U.K. economy has a long way to go, so investors should temper their expectations. Yes, business activity could get a boost, but when we consider the starting point is very low, we should look at any future gains critically before declaring a resounding win.

Energy Exposure Will Continue To Pressure The Fund

My next point goes back to EWU individually. Specifically, I want to take a look at the underlying holdings of the fund, with attention to the third largest sector of the fund. This is the Energy sector, which makes up over 13% of total fund assets, as shown below:

Source: iShares

This exposure is largely from just two companies held by EWU, which are BP PLC (BP) and Royal Dutch Shell PLC (RDS.A) (RDS.B). The good news, for myself and other "dividend seekers" especially, is that both these companies have fairly strong dividend track records, and their current yields are quite high. The bad news is a key reason why their yields are so high is because the share prices have been pummeled in the short-term. Simply, shares in the Energy sector have come under intense pressure over the past few months, as the price of oil has fallen off a cliff. Consider that, while broader equity markets have been falling in 2020, oil has lost roughly a third of its value during the same time period:

Source: CNBC

Clearly, this exposure has been a drag on EWU in the short-term. Going forward from here, investors could look at this two ways. One way could be to buy in to a beaten down sector, as it may represent a value opportunity. The other is to avoid it, as it could certainly see continued under-performance.

My takeaway is this is likely a reasonable buy area for the longer term, but investors who do buy in now need to anticipate further losses, so they need to consider their own risk tolerance. While Energy shares generally seem attractively priced, the macro-environment for this sector will be challenging for a while. Consider that this past week, OPEC+ failed to reach an agreement on production cuts going forward, which sent the price of crude spiraling downward. Investors had anticipated a significant action to be announced after this meeting so, when it did not, crude oil lost almost 10% of its value, its worst drop in a single day in five years.

The point here is that production is not likely to be cut to meet declining demand any time soon. As global growth concerns driven by coronavirus fears weigh on cyclical sectors, Energy will continue to hurt EWU's total return in the weeks, and perhaps months, ahead. While a bottom may be in sight soon, the current exposure is not something to get excited about at this time.

GDP Growth Has Been Weak, Outlook Not Clear

My final points touch on my rationale for lowering my outlook on EWU, as they relate to the British economy as a whole. Looking back at the past few years of GDP growth, we can see the U.K. has been struggling under the current climate. While 2018 saw improvements over the prior year, 2019 actually saw less growth on a year-over-year basis, as shown below:

Source: The Guardian

Of course, it has been known for some time that the U.K. has struggled as it contends with the fallout from Brexit. However, December's election and January's subsequent withdrawal was supposed to clear up some of the uncertainty. However, as we sit here in mid-March, the uncertainty surrounding whether or not the U.K. would leave has been removed, but the uncertainty surrounding what that actually means is still unresolved.

And the problem is this could be the reality for some time. According to a recent report by the BBC, the U.K. has completed nineteen trade deals for post-Brexit activity. While this may sound like substantial progress, consider that all nineteen of these deals were created while the U.K. was covered under EU trade agreements, and were simply "rolled over" to continue between the U.K. and the corresponding countries now that the U.K. is no longer in the EU. These deals, while important, only represent about 8% of U.K. trade, and include countries like Chile, South Korea, Israel, and Switzerland, among others. These are mostly smaller countries that do not make up the bulk of U.K. trade activity. In fact, the U.K. does more than half of its trade with EU-member countries and the United States, as shown below:

Source: BBC

Of course, this leaves some room for upside if the U.K. is able to strike a mutually beneficial deal with the EU. The problem is that negotiations will likely be on-going for a while, and the lack of progress so far is not encouraging. Similar to the Brexit negotiations, I would expect a lot of back and forth, posturing, and little in the way of results in the near term. Unfortunately, progress to date has not been encouraging, and both sides appear a bit contentious.

According to a report from the BBC, both the U.K. and EU governments have crafted opening documents on what they hope the trade deal will accomplish, as well as laying out items they do not wish to negotiate. The initial discussions appear to show critical differences on key topics.

For example, on issues concerning legislation, state aid, individual trade deals, and fishing licenses, both sides seem quite far apart. Taken one at a time, while the U.K. does not want to be beholden to current EU legislation that is updated in the future, the EU does not want to accept that exclusion, as it is concerned about the UK gaining a competitive advantage. With respect to industry support, the U.K. is looking for the ability to subsidize any domestic industries it chooses, while the EU wants to continue the current restrictions. Further, while the EU is hoping to create one deal that is all encompassing, the U.K. has laid out a vision for creating mini-trade deals for difference areas and sectors, such as immigration and fishing licenses in its seas.

My takeaway here is that these are substantial differences in critical areas, so I would not expect an agreement in the near term. This has exposed the reality that while Brexit is "done", the impact from Brexit continues to be a challenging economic environment, and one of uncertainty. With trade negotiations expected to occur through the Spring of this year, business leaders and consumers will need to contend with the uncertainty for the foreseeable future, and that will undoubtedly be a headwind for U.K. equities, and EWU by extension.

Bottom Line

My call on EWU was profitable, for a time, but has ultimately turned out to be too optimistic. While I saw the December election providing a tailwind to the economy and equities, that has not truly materialized, and EWU has fallen short. Looking ahead, I was tempted to view current levels as a clear buy signal, but I have re-evaluated my outlook and lowered my expectations. While the valuation and dividend stories are more attractive than the last time around, I see continued weakness in GDP growth and business investment in the U.K. as items that will hinder any chance of out-performance in the short-term. With ongoing trade negotiations unlikely to offer a resolution any time soon, I believe EWU will continue to face significant pressure compared to other broad equity funds. Therefore, while I see an argument for buying in to a beaten down area and obtaining an above-average dividend yield, I believe lowering my outlook to "neutral" at this time makes sense.

Analyst’s Disclosure: I am/we are long EWU. 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.