EWA: Some Reasons To Consider Australia In 2022

Main Thesis/Background

The purpose of this article is to evaluate the iShares MSCI Australia ETF (EWA) as an investment option at its current market price. This fund is managed by BlackRock (BLK), and its objective is to “track the investment results of an index composed of Australian equities”. This is an easy way for U.S.-domiciled investors to gain exposure to Australia, and is a fund that I follow regularly. When 2021 got underway, I actually had a neutral/modest outlook on EWA, and that outlook was reasonable in hindsight. While the S&P 500 had a tremendous past 12 months, the same was not the case for EWA:

As 2022 gets underway, we have been hit with both rising volatility and a sharp performance divergence from cyclical sectors like Financials and Energy compared to growth areas like Tech stocks. With market action making me a little nervous, I have been putting some cash to work outside U.S. borders, including in emerging and developed markets. As a result, Australia caught my eye, as the country has a significant valuation advantage over the U.S., as well as other positive attributes.

Specifically, EWA offers heavier exposure in some areas like Banks and Materials that are lighter in the S&P 500. This makes the fund a diversification play. Further, those are areas that will benefit from rising inflation and rates, generally, so they seem to be reasonable places to be. Of course, the pandemic continues to pressure the country, and strained Australia – China relations are major headwinds to consider. But ultimately, I think current buy-in points offer a reasonable risk-reward proposition at this time.

The Good – Valuation, Declining Concentration

To begin, I want to take a look at two key points on why investors may be looking outside the U.S., and why Australia, in particular, could fit the bill. Broadly speaking, equities are expensive right now – in both the U.S. and in the developed world. Low rates and a pandemic rebound have sent risk-on trades soaring, so buying in now is definitely more of a risk now than at most times over the past two years. Yet, when we consider relative valuation, non-U.S. developed stocks are some of the cheapest they have been in decades compared to U.S. equities. For perspective, the graph below shows the typical discount non-U.S. developed stocks offer compared to U.S. stocks. As you can see, the discount now is exceptionally wide:

This is an important point, and I hope it emphasizes why I have been building non-U.S. positions over the past few quarters, up to and including this week. Just as important, Australia is indeed a part of this trend. As a non-U.S. developed country, that could be expected based on the above graphic, but it is worth pointing out that EWA does indeed have a relatively attractive P/E:

While a P/E ratio of 18 is certainly not cheap, we should note this compares to a P/E of 25 sported by the S&P 500. So, the valuation discount is absolutely present here, and value-oriented investors may be interested as a result.

Beyond the valuation metric, there is another macro-point that I find compelling about Australia in relative terms. Similar to the U.S., the ASX 200 index (which is the primary index for Australian equities) is heavily dependent on a couple of sectors. In particular, Australia’s capital markets are dominated by the Financials and Materials sector, which is in contrast to the U.S.’ dominance on Tech, and to see lesser extent Consumer sectors. In itself, this presents a diversification argument for Australian exposure – it offers heavy weightings in sectors that are less dominant in a traditional U.S. portfolio that is long the S&P 500.

In addition to that benefit, there is another diverging trend between the two indices that I view positively for Australia. While S&P 500 has gotten more concentrated on its largest sector weighting – Tech – over the past decade, Australia has gotten less concentrated on its top sectors, as seen below:

My takeaway here is this gives investors a way to add some foreign exposure without adding to concentration risk. It helps to broaden out a portfolio by diversifying overseas, by adding to under-weight sectors in the domestic index, and to also get exposure to an index that is a bit more rounded out than what we have here at home. Those are positive attributes, in isolation, and I feel they support a thesis for considering Australia at the very least.

M&A Activity Has Been High – Signaling Confidence

Another signal of confidence for the broader Australian economy is the amount of merger and acquisition (M&A) activity that has hit the country recently. After drying up significantly in 2020, M&A activity surged in 2021. Heading into 2022, we have a backdrop of total M&A value well above what we have seen in recent years:

To me, this suggests big money players see some underlying value “down under”. They are putting cash to work through buying up companies and consolidating existing ones, likely in an effort to profit off the recovery that I would expect to materialize in the second half of the year.

At this point, vaccination rates and infection rates in the developed world are nearing very high levels, when we combine the two. There is only going to be so much support for continued restrictions and lockdowns as we push deeper into the year. With Australia being quite restrictive at the moment, I see the potential for accelerated growth in the near future, and the M&A activity suggests I am not alone in this thinking.

More Hawkish Rate Outlook Good For Banks

My next point touches on a tailwind for the Financials sector. While I mentioned that Australia’s index is getting less correlated over time, it is still very heavily tilted towards the banking sector in particular. As it stands now, Financials account for over 1/3 of fund assets, as shown below:

With this in mind, is there any news out there that can make on bullish on Australian banks?

Fortunately, the answer is yes. Similar to the U.S., Australia is facing rising inflation, and this is prompting revisions on how soon the central bank will begin to raise rates. While last year predictions suggested the country would not see rate hikes well into the future, that outlook has become much more hawkish. According to current expectations, rates could be going up in Q3 this calendar year, which is a big shift from now that long ago:

While August is still a long way off, and plenty could change by then, I still view this with a bullish mindset. Banks and lenders will make a better profit margin as rates rise, and I see this materializing as I do not expect inflation to moderate significantly to warrant a change in the tone at central banks.

Top Holdings Benefit From Rising Material Prices

A final point for EWA concerns the next largest sector by weighting – Materials. At over 19% of fund assets, Australia’s country fund is heavily exposed to changes in price for commodities and materials like copper, ore, iron, gold, nickel, among others. In fact, two metals/materials mining companies are in the top holdings list, as illustrated below:

As readers are probably well aware, commodity and materials prices have been rising broadly over the past year and a half. This is driven by rising global demand, supply-chain issues, labor shortages, among other factors. This has been benefiting mining and exploration companies, and given that inflation has remained stubbornly high, that trend has continued into 2022. In fact, both the two top Materials holdings for EWA, Rio Tinto Group (RIO) and BHP Group (BHP), are up near 10% this year already:

The good news is that the run for material/input prices may not be over. According to the most recent Manufacturing Business Outlook Survey conducted by the Federal Reserve Bank of Philadelphia, private firms are expecting inputs like energy costs and other rise materials to rise steadily in the year ahead:

The conclusion here is that if demand for energy, raw materials, and precious metals remains robust, prices are sure to keep rising even from these elevated levels. It is going to take a while for supply to catch up, and in the short term, this benefits the materials sector broadly. EWA is a way to gain exposure to this under-represented sector in the U.S. and supports my bullish take.

Bottom Line

I see multiple reasons for considering Australia at the moment. The stocks are priced relatively well, interest rate hikes should boost bank stocks, and materials prices will probably continue to go up, supporting some of the fund’s top holdings. With U.S. equities seeing some increased volatility, the time seems ripe to focus on diversification. As a result, I will be considering adding EWA to my non-U.S. positions, and I encourage readers to give this fund some consideration at this time.