The iShares MSCI EAFE ETF (EFA) tracks the investment results of large and mid-cap equities in developed markets excluding the U.S. and Canada. Since April 2018, EFA touched the bottom in January 2019 and then rebounded to the price level of 65. What are the economic and geopolitical factors that are driving the price movement? Going forward, what direction will the price of EFA move in?
EFA focuses on developed markets in East Asia, Europe, and Australia. The European market represents more than 55%, followed by Japan which represents 24%.
Source: Blackrock website
The top three industries in EFA’s portfolio are financials (18.83%), industrials (14.22%), and consumer staples (11.57%).
Source: Blackrock website
Due to its geographic concentrations, EFA is specifically exposed to Asian and European macroeconomic risks. Besides that, since the financial sector takes up the highest percentage of the portfolio, EFA’s portfolio return is highly correlated with the financial sector’s revenue growth and profitability.
The US and China trade war is escalating, and it deeply hurts global economic growth. The damage not only comes from punitive tariffs but also from uncertainties brought to the global financial market. According to the IMF in the latest World Economic Outlook, the global expansion has weakened. The global economy is projected to grow at 3.5 percent in 2019 and 3.6 percent in 2020, 0.2 and 0.1 percentage point below projections in October 2018. This is mostly due to weaker performance in Europe and Asia.
Facing the China-U.S. trade disputes and political risks of a “no-deal” Brexit and raging nationalism, the ECB sharply cut its eurozone growth forecasts for 2019 from 1.7% to 1.1%. In Asia, developed economies like Korea, Japan, and Singapore are highly dependent on trade between the US and China. As the volume of trade and business activities contracts between the two countries, trade hubs like Korea and Singapore also see risks of an economic recession looming larger.
All these macroeconomic factors will reflect on EFA’s portfolio return. As economic growth slows down, business profits and households’ disposable income will also decrease. This leads to declining demand and profitability in sectors including industrials, consumer goods, and materials, which are the major industries that EFA covers.
Financial Sector Outlook
In 2018 we saw rising interest rates in the US and the progressive withdrawal of quantitative easing in Europe due to global economic recovery. In 2019, in reaction to the recession threats, major central banks including the U.S. Federal Reserve and ECB all halted their plan to raise interest rates. The Bank of Japan continues to keep its negative benchmark interest rate for at least the rest of 2019.
The financial sector, which takes up the highest percentage in EFA’s portfolio, is particularly sensitive to fluctuations in interest rates. Generally speaking, institutions such as commercial banks, investment banks, and insurance companies see their profitability decrease with interest rate cuts because of their massive cash holdings.
Thus, whenever economic data or central bank comments hint at rate hikes, stocks in the financial sector begin to rally first and vice versa. Although it usually takes a year or longer for any change in interest rates to be felt in the economic system, investors’ response to such change in the stock market is more immediate.
In the current environment where economic growth is weak worldwide, the loose monetary policy will be likely to last at least until 2020 in developed economies. This is bad news for the banking sector’s performance, and that is a significant downside risk for EFA’s portfolio return.
Developed economies around the world are not immune to the global economic recession. Geopolitical risks including the Brexit, escalating global trade tensions, and the slowdown in China causes further deterioration in the stock market sentiments and macroeconomic performance in these countries. Going forward, we see significant downside risks in the revenue and profitability of portfolio companies covered by EFA, and the pessimistic market sentiments are not likely to recover any time soon. Before making any decision to buy, investors need to take these risks into serious consideration.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.