VEU: Foreign Stocks Are Cheap For Good Reasons (NYSEARCA:VEU)

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FrankRamspott

Investment Thesis

The Vanguard FTSE All-World ex-US ETF (NYSEARCA:VEU) invests in a broad basket of international stocks. For those seeking geographical and sectoral diversification, VEU is a good candidate for your watchlist. In light of the recent price decline, many are wondering if VEU is a buy at current levels. I personally believe that the near-term environment remains very challenging for international markets, which makes the risk-reward tradeoff for potential buyers unattractive at the moment. A strong dollar, higher rates for longer, and slowing economic growth are all contributing to prolonged weakness in equity markets around the globe.

Strategy Details

The Vanguard FTSE All-World ex-US ETF tracks the investment results of the FTSE All-World ex-US Index. The strategy provides exposure across developed and emerging non-US equity markets around the world.

If you want to learn more about VEU, you can find a detailed list of documents here, including the summary prospectus and the most recent semi-annual report.

Portfolio Composition

VEU invests ~20% of total assets in Financials, followed by Industrials (~13%) and Consumer Cyclical stocks (~11%). The largest three sectors have a combined allocation of approximately 44%.

Morningstar

Morningstar

In terms of geographical distribution, over 15% of funds are allocated to Japan, followed by China (9%) and the UK (9%).

Morningstar

Morningstar

~35% of the portfolio is invested in large-cap “blend” stocks, characterized as large-sized companies where neither growth nor value characteristics predominate. Large-cap issuers are generally defined as companies with a market capitalization above $8 billion. The second-largest allocation is large-cap value stocks (~27%). Over 85% of the portfolio is invested in large-caps, which are generally considered to be stable companies, with the remaining amount invested in mid-caps.

Morningstar

Morningstar

VEU is currently invested in 3,620 different stocks. The top 10 holdings account for ~9% of the portfolio, with no single company weighing more than 2%. The fund is very well diversified across issuers and fulfills the criteria of a traditional ETF, which investors purchase for diversification purposes. The top 10 holdings include blue chips such as Nestle, Roche, and Novartis.

Morningstar

Morningstar

Since we are dealing with equities, one important characteristic is the portfolio’s valuation. According to data from Morningstar, VEU trades at ~1.4x book value and ~11x earnings. While these multiples are relatively low, it’s important to take these values with a grain of salt given the macro outlook and portfolio structure. Over 40% of the portfolio is invested in cyclical stocks, which goes well above 50% if we add sensitive sectors to the data. If we are entering a phase of slower economic growth as I believe we are, these sectors are the most vulnerable to a downturn, and likely to experience higher drawdowns.

Morningstar

Morningstar

A Review Of Past Performance

I have decided to compare VEU’s price performance against the Vanguard Total World Stock ETF (VT) over the last 5 years to assess which was a better investment. Over that period, VT benefited from strong U.S. equity market returns and outperformed VEU by over 29 percentage points. To put VEU’s returns into perspective, a $100 investment in this fund 5 years ago would now be worth $98.74 including dividends, which is a modest absolute return.

Refinitiv Eikon

Refinitiv Eikon

Although VEU’s returns turn positive if we extend the timeframe, they remain meager relative to VT, especially when you account for the favorable macro environment of the last decade. Given a deteriorating macro outlook, I am skeptical that VEU will do much better over the next 2-3 years.

Refinitiv Eikon

Refinitiv Eikon

Slowing Economic Momentum To Weigh Down On International Stocks

Global growth momentum is weakening as central bankers join forces together to prioritize inflation. In order to address the inflation issue, policymakers are conducting the most intense hiking cycle in decades as illustrated by the chart below from Citi, with the risk of hampering near-term economic growth.

Citi

Citi

Citi

Citi

Economic momentum took a hit in recent months, and expectations of a soft landing are decreasing by the day. According to the most recent PMI survey data, global economic production dropped in August 2022 for the first time since June 2020. Although minor, the slump represents a more widespread worsening in output and demand circumstances, both by industry and location. Companies are also being more cautious about cost-cutting and hiring in light of the deteriorating economic situation. Moreover, for the first time since early 2020, the PMI output of all four major developed economies fell. While the Eurozone, the UK, and Japan all saw mild contractions, the U.S. experienced a more severe contraction. All four countries reported reduced industrial production levels, which were matched by decreasing service sectors, with the U.S. reporting by far the greatest service sector drop. This certainly feels like a risk-off environment, with the exception of strong labor markets both in North America and Europe. Since equities carry significant volatility, I believe the risk-reward tradeoff is negatively skewed for buyers over the next 18 months.

S&P Global

S&P Global

In the midst of this unprecedented shift in monetary policy, collateral damage in the form of weakening foreign currencies has extended to the point where the dollar is reaching a multi-decade high. This comes as no coincidence since financial conditions are tightening across the board and therefore, the global financial system requires more dollar collateral. On top of that, the unprecedented geopolitical tensions are making the dollar even more valuable, and perhaps the only safe haven in town. For those calling for a dollar reversal in the near term, I believe it’s still premature, and the outcome will be largely impacted by the path of the Ukrainian conflict, the Fed’s monetary policy, and global economic growth. Until then, international stocks carry considerable FX risk and should trade at a premium relative to US stocks.

Refinitiv Eikon

Refinitiv Eikon

All in all, VEU’s short-term prospects look unattractive to me for the following reasons:

  • Tighter financial conditions are negatively impacting equity markets around the globe. Policymakers are committed to fighting inflation, and lowering asset prices is part of the plan.
  • Economic momentum losing steam. As a result, I expect volatility to remain elevated. Stocks are not a volatility hedge, on the contrary, they mostly tend to be negatively correlated.
  • Stronger dollar for longer. The Fed reaffirmed its commitment to higher rates for longer at the most recent FOMC meeting. This is coupled with decreasing liquidity in financial markets across the world, and a higher demand for dollar collateral, keeping the dollar in a higher range versus historical values.

Key Takeaways

VEU invests in a diverse portfolio of foreign equities. Given the recent pullback, many investors are questioning if VEU is a good buy at these prices. Personally, I believe that foreign markets are facing an unfavorable economic backdrop, making the risk-reward tradeoff unappealing to potential buyers. A strong dollar, higher interest rates for a longer period of time, and sluggish economic data are all likely to impede the prospects of international stocks in the near term.

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