iShares Core MSCI Europe ETF: expected catch-up (NYSEARCA:IEUR)
If you’re a subscriber to the Lead-Lag report, you’ll notice that the outlook for international markets is something I’ve been highlighting throughout this year. I believe there is plenty of value to be found in this pocket if you know where to look. One area that seems particularly tempting is European markets. If this is ground you want to explore, you might consider looking at the iShares Core MSCI Europe ETF (NYSEARCA: IEUR). It is one of the largest European ETFs, with almost $5.5 billion in assets under management. IEUR covers large, mid and small cap stocks in developed countries across Europe. It is also one of the most profitable options with an expense ratio of only 0.09%.
The relative growth gap may not be large, but the European interest rate narrative has only recently picked up
From the point of view of GDP growth, there is not much to choose between the local economy and Europe; the United States is expected to post GDP growth of 4% this year while Europe is not left out with an expected figure of 3.9%. Both regions are expected to slow towards the 2.5-2.6% mark the following year.
The main catalyst for IEUR over the medium term is what might happen with rates; Much of the debate over the past few months has centered on how many rate hikes the US Fed will bring in 2022. European views had remained rather subdued until last week as inflation was thought to remain a passing fad. We have now seen some change in this narrative with major institutions such as Goldman Sachs betting that we could see a quarter point rise in interest rates in September and December. This would finally lift benchmark deposit facility rates away from negative territory. You can imagine all the good it would do for the beleaguered European banking sector which has held a portfolio of negative yielding bonds for years.
As noted in The Lead-Lag Report, one could perhaps argue for European banks to serve as notable proxies to play a potential merger trade.
Of course, before rates can be raised, we still have to see net asset purchases stop, but I don’t think the ECB can be complacent about the current situation; Members of the Bundesbank have suggested that the economic costs of waiting too long could prove pernicious. While there is no official word yet, one cannot ignore recent trends that have plagued European bond yields. Incidentally, the 10-year German Bund yield, which had been in the red since Q2-19, is trading above the +0.2% levels all week (last month it was closer to -0.06%). Either way, note that US financials had rallied strongly on the prospect of high rates from the Fed and we could see a similar picture playing out with European banks.
Speaking of rates, it’s also worth noting that the Bank of England is quite aggressive in this space and recently 4 out of 9 policymakers wanted to raise rates by 0.5% instead of the 0.25% that ended up being agreed. The BoE statement also implied that peak inflation was still miles away, so this higher rate environment will also trickle down to UK financials. Incidentally, UK-based stocks make up the largest share of IEUR’s portfolio at nearly 25%.
This pivot to higher rates will not only help European financials (incidentally the largest sector within the IEUR), but you also need to consider how it might help boost the euro which, in all fairness, has had a difficult few months until recently. EUR/USD’s recent rise could serve as the first step in a potential multi-month rally as the euro seeks to make up for lost time.
While there doesn’t appear to be a significant advantage in GDP differentials between the US and Europe, note that there is an opportunity here to access roughly the same earnings growth profile at lower valuations. Basically, IEUR’s equity portfolio is expected to generate long-term earnings growth of 13%, close to the long-term earnings growth predicted by the SPY of 13.9%. Meanwhile, you can own IEUR at a current forward P/E multiple of just 13.5x, a 34% discount to the SPY.
Pictorially, too, one can also get an idea of the value offered here; over the years, the performance of IEUR against SPY has deteriorated over time and currently it is close to its lowest level; At such low levels, you would think that some bargain hunters would come on board, causing a rotation from SPY to IEUR.
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