Main thesis and background
The purpose of this article is to evaluate the SPDR EURO STOXX 50 ETF (NYSEARCA: FEZ) as an investment option at its current market price. This is a fund that invests in large capitalization European companies, and the one I used to consider when looking for an exhibition abroad. However, in 2022, my outlook on this has been modest, driven primarily by concerns about the military escalation of the Russian-Ukrainian war and general economic weakness. For this reason, I placed a “Holding Rating” on the fund on my last exam back in April. In hindsight, this was a reasonable call, with the FEZ and S&P 500 having since fallen:
Given this stock price correction since this article, I wanted to take another look at FEZ to see if I should upgrade it to “buy”. After all, cheaper prices often represent better value.
Despite this reality, there are too many headwinds for me to consider spending money at these levels. While the decline we experienced in 2022 is likely limiting further declines, I don’t really see a very bullish backdrop. The war in Ukraine is taking root, worsening supply chains and darkening the continent’s energy prospects. Additionally, economic activity is slowing, which is often a precursor to a recession. With other developed economies offering value and without these geopolitical risks, I will continue to maintain a “hold” rating on FEZ and look elsewhere for value.
Ukrainian headlines do not inspire confidence in continental Europe
As a recap for readers who may not follow FEZ closely, this is a fund that is primarily focused on continental Europe – primarily Central, Western and Southern Europe. In practice, the fund offers exposure to some of the biggest European companies, which means that France and Germany are strongly represented. Beyond that, investors would be exposed to countries like the Netherlands, Italy and Spain, among others:
It should be noted that this fund excludes the United Kingdom and has very little exposure to Ireland.
Personally, it’s not a “bad” line-up. But it’s not the one I really want to be overweight right now. The reason is that Central Europe, especially Germany, is right in the crosshairs of the Russian-Ukrainian conflict. As the continent’s largest economy, they have the most at stake in terms of economic activity and are close enough to the conflict that a spillover could affect them directly.
Of course, Eastern Europe stands in the way. And these nations are mostly considered “emerging”, so they are not included in this fund which focuses on the biggest companies. So that’s a positive point. But I also wouldn’t advocate investing in this region right now, given all the uncertainty.
While Central and Western Europe is not really at risk of being drawn into a military conflict at this stage, it may have to act if Russia expands its ambitions beyond the Ukrainian border. It seemed far-fetched at the start of the crisis, but it’s becoming clear in the Western world that we don’t know what President Putin really wants. This makes it a more dangerous situation, and therefore less investable.
To understand why, let’s take a look at some of the recent headlines to come out of the region. This is a fluid and ongoing situation, so we don’t want to put too much emphasis on any particular development. But the main thing is that there is not much to do:
The aim is to show the diversity and severity of recent headlines. They are mainly negative and have an impact on a series of problems: a reluctance to respect ceasefire agreements, foreign casualties and threats of energy shortages.
What I mean is that the magnitude of this conflict continues to worsen. It has international implications and developments are becoming increasingly pessimistic. It just makes Europe something I want to be very cautious about at the moment. This makes me reluctant to recommend FEZ, a European-focused ETF.
Europe’s economic activity is slowing down
While my macro view in the previous paragraph is significant, readers should be thinking “I don’t invest in Russia or Ukraine”. It’s true. FEZ does not own a single Ukrainian or Russian company, nor is Eastern Europe represented (just minor direct exposure to Finland). So, in all fairness, Ukraine’s troubles don’t necessarily cloud an investor’s judgment about buying international companies based in Germany or France. This is a valid argument, given that these companies are remote from the conflict (for now) and generate much of their revenue and profits overseas.
The idea could easily be that Central Western Europe is not Russia or Ukraine, so there is not as much risk in buying this fund as it seems. Personally, I agree with this feeling that the Russian-Ukrainian conflict is not enough in isolation to completely avoid Europe. The problem is that this is not the only problem with buying FEZ. For example, economic activity is slowing across the continent, and this is only partly the fault of the war. Other catalysts are high inflation and rising interest rates. These issues are putting pressure on business sentiment and ultimately activity:
What this shows is that there is a decline in corporate purchasing and manufacturing. The expansion that had gathered momentum reversed significantly. This puts pressure on the outlook for corporate earnings in the Eurozone and reinforces my reluctance to buy this fund.
The feeling sometimes speaks
Another sign of weakness is declining business and consumer confidence. This is not surprising given all that is happening in continental Europe. Between war, inflation and worries about the winter season due to Covid-19 and tight energy supplies, who can blame European business leaders and consumers for being pessimistic?
Unfortunately, trust has dropped dramatically, especially among the consumer class, as shown below:
This is a concern for any region where I would consider investing. But that’s especially true for a Eurozone index that FEZ tracks because that index is very consumer-centric. Consumer discretionary is the fund’s largest sector weighting, and when we add consumer staples, we see that over 29% of total assets are directly tied to consumer spending:
The conclusion here is that many of the companies held in FEZ’s portfolio are affected by rising levels of inflation and falling levels of confidence. This is a tough proposition, and reiterates the need to be careful when approaching this space.
There is an inherent value
My tone in this review so far has been quite negative. Yet my rating is not “down” on this fund. While I struggle to come up with a solid investment case, the truth is that this fund’s year-to-date weakness inherently limits any further declines we can see. Is there a possibility for more losses? Absolutely. But I believe these losses will be contained that I would not advocate selling outright on FEZ or Europe as a whole. Hence the logic of the “hold” decision.
To understand why, let’s look at some simple steps. First, the P/E ratio on the tracks of the FEZ index is very low, below 13:
That’s significantly lower than the S&P 500, giving US investors a valid reason to diversify.
Second, FEZ represents better value now as an income game. The fall in prices coincided with an increase in the level of distribution. This represents a much better opportunity for those who are primarily concerned with a dividend stream. The current yield is around 4%, strongly boosted by the dividend growth the fund has recently experienced year-over-year:
|Breakdown June 2021||Broadcast June 2022||Annual change|
Source: State Street
This demonstrates that there are positives for FEZ. The story isn’t all bad and there may be an argument for keeping positions or even buying a new one. It’s not enough for me personally to push this fund into the buy zone, but the lower P/E premium and higher dividend stream are indeed attractive attributes.
Europe currently remains in a difficult situation in terms of geopolitical risks and economic uncertainty. This makes a bull case for FEZ hard to make. Germany is an important economy for the Eurozone and for this particular free zone, and it happens to be one of the economies most exposed to the Russian invasion. This is mainly the result of its heavy dependence on Russia for the supply of natural gas. This puts pressure on what consumers pay for energy and limits the Germans’ ability to negotiate any kind of peace treaty. Their influence is limited.
France, the most weighted country in this fund, faces similar problems, but not to the same degree. This puts the country at risk of recession, as well as the EU area as a whole. It seems to me that these are areas to avoid at the moment. Is there opportunity when the outlook looks bleak? For sure. But I see the outlook darkening in the coming months, suggesting that a more opportune chance will present itself.
Accordingly, I will avoid FEZ for the time being. I will remain focused on the US, as well as other developed markets like Canada, UK and Australia. The risk-reward ratio seems more advantageous in these regions, and I caution readers to be very selective when buying FEZ at this time.