A Closer Look at Germany June 28, 2010, Bill Witherell, Chief Global Economist
The German economy, the largest in the Eurozone, is probably the best situated to take advantage of the weakness in the euro. Past market-friendly economic reforms have significantly improved the international competitiveness of German firms, and the German efforts to develop markets in the rapidly growing Asian markets are already beginning to pay off. Business confidence as measured by the Ifo Business Climate Index reached 101.8 in June, which marks a return to the levels of mid-2008, suggesting the weak euro is already positively affecting German exports. Unemployment has declined for eleven consecutive months, and employment has been rising since February.
In the latest OECD Economic Outlook,1 the German economy is seen to be recovering, the rebound driven mainly by exports advancing some 10% this year and expected to rise almost 9% in 2011: “The underlying growth momentum is intact, although negative one-offs affected the economy around the turn of the year. Growth is expected to pick up strongly from the second quarter onwards as improvement in world trade continues and firms gradually raise their investment expenditures.” GDP growth in both 2010 and 2011 is projected at about 2%. That is double the (at best) 1% growth we expect for the Eurozone as a whole this year.”
Some have argued that austerity programs in Europe, including the 80-billion-euro budget-consolidation package announced by the German government, will terminate the ongoing recovery and cause a double-dip recession. We doubt this will occur, particularly in the case of the most competitive of the Eurozone members: Germany, France, Netherlands, and Austria. The austerity programs are to be phased in over several years, while the weak euro is already having a beneficial effect on exports.
Having decided to give emphasis to Germany in our International and Global Multi-Asset Class portfolios, we need to identify the most appropriate ETF(s) to implement this strategy. (Note that we use only ETFs to provide exposure to equity markets in our investment portfolios.) The iShares MSCI Germany Index ETF, EWG, would appear to be the obvious choice. Nevertheless, we check a number of criteria before making our selection. A first consideration is liquidity. With very few exceptions, we will not invest in ETFs that have less than $50 million in assets under management. EWG, with $1367 million net assets, is very liquid. Second, we look at a number of factors that relate to the quality of the ETF, to ensure that an ETF does and will continue to do a good job tracking its index, and that it will generally perform the way we expect it to. Relevant factors include historical tracking error, index replication strategy, fund structure, tax distribution history, historical performance, and fund closure risk. Here also, EWG passes the tests.
Finally, we examine closely the relevance of the ETF to ensure that it captures the market we are targeting, in this case those elements of the German economy that will be benefiting from the projected export-driven rebound in growth. This requires drilling down into the ETF sector and industry weightings and individual security holdings. EWG is highly diversified, holding 51 individual securities. The top five sectors are financials, 18.18%; industrials, 15.50%; consumer discretionary, 14.29%; materials, 13.58%; and utilities, 12.95%.
The importance of the financial sector is characteristic of all European economies, due to the much greater importance of bank finance for European firms than is the case in the US. Two of the 10 top securities held in EWG are the largest German bank, Deutsche Bank, and the insurance firm Allianz. In view of current concerns about the health of Eurozone banks, we will look carefully at the soon-to-be-made-public bank stress tests.
The other major EWG holdings are highly relevant to our strategy, including Siemens AG, Europe’s largest engineering conglomerate; BASF SE, the world’s leading chemical corporation; Bayer AG, the chemical and pharmaceutical firm; E.ON AG, Germany’s leading energy firm; Daimler, the very successful auto and truck manufacturer; and SAP, a leader in software for business. These firms appear well-situated to add value for investors this year and in 2011. Accordingly, we are using EWG to provide overweight exposure to the Germany equity market in our accounts.
1 OECD Economic Outlook 87, May 2010, www.OECD.org, pages 1050109.
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