EWU: I Don’t Love The Investment Backdrop In The UK Going Forward

Main Thesis & Background

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. 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 looked optimistically on British equities when the summer got underway. After that initial call, EWU did perform fairly well, but those gains have mostly evaporated. Over three months later, the fund is sitting with a modest profit:

Despite this modest gain, I am reluctant to anticipate more gains going forward. I continue to see a challenging backdrop across the pond and this makes me reluctant to put more cash in to this sector. Simply, I am concerned about overall gains and, just as importantly, I believe out-performance against US equities is unlikely to materialize in the short-term. Therefore, I am downgrading my rating to “hold”, and will explain why in detail below.

Bank of England Likely to Continue Hawkish Path

One aspect in particular that sets both the UK and Euro-zone apart from the rest of the world is that inflation remains relatively high there. I compare this to other developed nations like the US – but this story extends beyond our borders. Still, while inflation has been coming down recently, it remains much too high for central banker’s liking:

So what does this mean? To me it suggests the Bank of England can’t declare “victory” in its fight against inflation. Extending that thought, rates are unlikely to move lower any time soon and very well could still go up.

And this is precisely what the market is thinking. Despite the BOE’s benchmark going up at a very fast clip over the past year, market expectations are that the rate will continue to rise to tame inflation in Q4 and early Q1 2024:

The simple takeaway is this is not a positive backdrop for consumers or businesses. Inflation is eating away at buying power and higher rates is making borrowing more costly. This is central to why EWU has under-performed in recent months and for all intensive purposes it looks like the dynamic is set to remain in place going forward. Given this reality, it is hard for me to stay bullish on funds like EWU.

I Believe Other Forward-Outlooks are too Optimistic

My next reason for downgrading British-based EWU is that I don’t see this as much of a contrarian play anymore. When I really got behind this investment towards the end of last year, everyone was predicting the doom and gloom of the UK. That seemed like an overwhelming buy signal to me – and it worked out very well. Unfortunately, today’s environment is seeing economists upgrade Britain – which tells me to be cautious.

For an example of what I am talking about, let us look at some forecasts from KPMG. After predicting a modest year in 2023, then suddenly see a backdrop where GDP growth will rise in 2024, unemployment will increase, and inflation will shoot lower:

To me, this just seems like wishful thinking. How is inflation going to drop by 4-5% when economic growth rises? It is nonsensical – especially when interest rates are expected to decline (their forecast, not mine). I just don’t see the logic here – and it looks to me like they are simply finding an argument they think investors want to hear. Well, I invest without emotion, and the bull case for Britain is not one I would bank on if these lofty predictions are what is needed.

Economic Indicators Flashing Weakness

Digging deeper in to why I am not as optimistic as other analysts, we come to recent economic data. While many are suggesting both the US and the UK will avoid a recession this year, weak growth is still the story of the day. And while the US seems poised to recover more strongly next year, I am not so sure about Britain.

The reason is that there is notable signs of deceleration through the summer months. PMI figures for both manufacturing and services have seen sharp declines as of August – sending off poor signals for future growth expectations:

It should be clear why I have concerns at this juncture. The UK’s economy is suggesting go-forward weakness and that is not the environment I want to see as an investor. Will they avoid a recession? Economists seem to think so – and that is a good thing. But weak growth, high inflation, and elevated interest rates do not really scream “bullishness” to me. For these reasons, my downgrade to “hold” for EWU seems justified.

The Dividend Story is Appealing

I thought it was important in this article to discuss the key reasons for why I am downgrading EWU. Because of this the article has a negative slant. But I am not a complete bear here – I want to make that clear. There are reasons for holding this exposure and they go beyond simple geographical or sector diversification. One of the reasons is the dividend story – which compares favorably to the large-cap US index.

To illustrate, consider that at time of writing EWU has a yield in excess of 3%. Not too shabby for an all-equity fund. Furthermore, despite all the challenging macro-economic conditions, British companies have still been able to grow their dividends on average. We know this is the case because EWU has pumped up its semi-annual dividend on a year-over-year basis:

Click to enlarge

Source: iShares

This is a healthy amount of dividend growth and I am sufficiently pleased with this option as an equity income play going forward because of it. While other headwinds remain that make me cautious, EWU’s yield helps to buffer some of this downside risk.

UK Cheap Compared to Rest of the World

Another aspect to look on favorably with respect to British equities is the relative value proposition. We know that stocks in the US are not “cheap”, and India has gotten much more expensive over the past year. Even Japan, which normally had steep discounts to US and other global stocks, has seen a rally in 2023 that has pushed up its forward P/E substantially. By contrast, UK stocks seem cheaply priced both in isolation and in relative terms:

The challenge here is knowing if this really is a “buy” signal. The truth of it is that British stocks have been “cheap” for a long time. Since before Brexit, after Brexit, and now – UK stocks have looked attractive on this metric especially compared to their US counterparts. And still, over time, the large-cap US stocks have out-performed over most timeframes anyway.

What I take away from this is that it is just another piece of the puzzle to keep in mind. By no means would I completely write this off, but I would not use valuation as a buy argument on its own. The reason being British stocks could remain “cheap” for a very long time – not delivering the “alpha” that readers here are looking for.

Bottom Line

EWU has squeezed out a modest gain in the short-term and there are reasons to stay optimistic. The relative cheapness of the large-cap index and the potential for continual declines in inflation metrics suggest more gains could be on the way.

But I’m not so sure. I believe forecasts for a rebound next year are a bit too lofty and see a challenging macro-environment for British stocks over the next few quarters. Economic indicators suggest weakness ahead and the valuation edge for British equities has been present for a while without sparking a rally.

This continues to be a reasonable option for a diversifier and an income play, but I don’t think out-performance or “alpha” are likely to occur any time soon. Therefore, I am downgrading my outlook to “hold” and suggest my followers approach any new positions selectively going forward.