EWU: I'm Bullish On Britain As A Diversifier (Rating Upgrade)

Summary

• EWU has seen gains of late and I believe more could be on the way.
• British stocks, and this fund by extension, are cheaply priced compared to the S&P 500.
• The IMF recently upgraded its growth forecast for the British economy.
• This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

CHUNYIP WONG

Main Thesis & Background

The purpose of this article is to evaluate the iShares MSCI United Kingdom ETF (NYSEARCA:NYSEARCA:EWU) as an investment option at its current market price. The fund's stated objective is "to track the investment results of an index composed of U.K. equities." The fund offers exposure to large and mid-sized companies that are based in the United Kingdom.

I had favored this fund as a solid contrarian investment in early October because the prevailing market sentiment was heavily against Britain and British stocks. This resulted in some strong gains, leading me to turn more cautious when 2023 got underway. In hindsight, it made sense, as the U.S. has been a strong performer compared to other developed markets. This includes the U.K. (and EWU by extension) since that review:

Fund Performance (Seeking Alpha)

Given this dynamic, I wanted to give another updated take on EWU with my outlook for the second half of the year. For multiple reasons, I see a lot of merit to adding to my position here, leading me to upgrade this to a "buy". I will explain those points in detail below.

U.S. Gains Driven By Few Stocks

To start the review, I will focus on why I am looking beyond U.S. borders right now. After last year's performance, 2023 certainly looks good domestically. With some exceptions like Banks, we have generally had a good year, albeit with some volatility in recent months.

However, one point of major concern for me is that many of the index gains we have seen are actually coming from just a handful of stocks. This tells me investors are very enthusiastic about some big U.S. large-cap names, but are getting very cautious about the rest of the market. For perspective, the chart below compares the performance of the "top 5" stocks within the S&P 500 against the rest of the pack:

Index Performance (Charles Schwab)

As someone who is mostly US-oriented (and S&P 500-oriented!), I have certainly welcomed this move in the past few quarters. But looking ahead, it has me feeling cautious. How much longer can a handful of stocks prop up this market? If the last few trading weeks are any indication, perhaps not much longer.

With this in mind I continue to branch out amongst my non-US holdings. This includes EWU, but this thesis is relevant for other developed markets as well. I personally like Ireland and Canada, and many investors seem keen on Germany and Japan. The point I am making is that I use this as a justification to look beyond US borders collectively, and will discuss the merits of EWU specifically in the next few paragraphs.

U.K. Seeing A Welcome Drop In Inflation

Digging into the broader U.K. investment environment, one metric I view positively is the decline in the key inflation gauge. This is consistent across the developed world (US, EU-zone, and UK), but it is especially notable for Britain because it had one of the highest rates of inflation over the past year:

Inflation Rates (Yahoo Finance)

What this means to me is that the U.K. had a disproportionate inflationary impact compared to other developed markets. This was surely punishing sentiment and consumer spending to a higher degree, so seeing a drop in headline inflation is a more welcome sign there than elsewhere (in my opinion).

While broadly good for the U.K. investment environment as a whole, this extends to EWU directly. The fund has roughly one-quarter of its assets in consumer-oriented sectors, so the positive impact should be clear:

EWU's Sector Breakdown (iShares)

For me, this helps support a buy rating. The fund is heavily exposed to the consumer and the consumer is about to get some relief in inflationary terms. It remains a difficult environment - no doubt about that. But at this point, any progress is a big win.

Government Borrowing Juices The Economy

My next thought may seem like a contrarian idea but it should have positive implications in the short term. To be clear, I do not think unsustainable government borrowing is a good way to grow an economy. I would prefer developed governments around the world were more responsible in how they spent revenue and how they worked to grow internally. But, alas, what I prefer is not the current mandate for most governments (developed and non-developed). So I am left with the task of figuring out how to capitalize on what they are actually doing - not what I would like to see.

With this in mind, I think the U.K.'s government is on a fairly negative course long-term. But in the short term, I believe the way they are juicing the economy could work to investor's advantage. Again, I do not believe this is the best course of action for the country, but I do believe government borrowing is a stimulative measure that tends to be positive for equities. With that thought in mind, I view the current spending plans favorably:

UK Government Borrowing (Bloomberg)

The takeaway for me here is that for the next twelve months, the government is not going into restrictive mode. Interest rates are rising, which is a headwind on this front. But the amount of government borrowing is sure to continue to be inflationary. This is not automatically bullish for stocks, but in this environment I think it will be. EWU has been performing reasonably well and continuous government spending is unlikely to derail that fact. This supports my buy rating at the moment.

Recession Could Be Averted

Another positive development for the British economy is that the U.K. is now expected to avoid a recession this year, at least according to the International Monetary Fund (IMF) in its statement earlier a few weeks ago in late May.

In that statement, the IMF updated its growth forecast for the U.K, which it expects the UK to grow by 0.4% in 2023. While this may not sound too favorable, we have to consider that its prior forecast was that economy would contract by 0.3%. So this is a sharp move for a developed economy.

Clearly, economists believe the U.K. has avoided the "worst". But investors have not really priced this in. If we compare the P/E of British stocks with American ones, we see there is a lot of inherent value across the pond:

UK P/E versus U.S. (Forward) (Schroders)

This indicates a near record discount for U.K. equities against their U.S. peers right now. As a more value-oriented investor, this extends support for why I would want to own a fund like EWU that is filled with these relatively discounted holdings.

Story Isn't All Rosy

I stand by my call that EWU offers some short-term value here. I see the British economy holding up better than expected and a downtick in inflation is generally positive considering how high it has been. But that doesn't mean there aren't headwinds. Readers need to carefully consider these before diving in. I like this as a diversifier, but that doesn't guarantee gains by any stretch.

And the problems are multi-fold. One is that the government there is struggling with public support as its economic plans have been mixed. Another is that many British homeowners have adjustable rate mortgages, which means budgets are going to be tight as higher rates begin to kick in. Finally, confidence within the business community is weakening of late. While it is still elevated from Q4 last year, the recent drop isn't exactly comforting:

Business Confidence (UK) (Lloyds Bank)

We all know that confidence readings are not an exact science. But they can often signal a slowdown in investment, hiring, or other business-related spending. If that winds up being the case, the more optimistic growth forecast from the IMF is called into question. Simply put, there are many challenges on the island facing both consumers and businesses and this clouds the model for future returns for EWU as a result.

Bottom line

EWU continues to pump out gains and I see a strong chance that reality will continue. The fund is cheaply priced compared to U.S. stocks, will benefit from a high rate of government spending, and has the bonus catalyst of higher growth forecasts for Britain fueling some optimism.

There are downsides, of course. These include persistently high inflation and a drop in business leader confidence in May (although it is still well above the levels we saw in late 2022). Further, the current ruling government is losing popularity and Brexit remains a growth headwind.

Despite these challenges, I think the good outweighs the bad. I have real concerns with U.S. stocks at the moment, which tells me it is time to lock in some profit (which I have been doing) and look outside our borders for value. I believe EWU is as prudent a play as any, and that is why I am upgrading it to a "buy" at this time.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of EWU either through stock ownership, options, or other derivatives. 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.