Thomas Faull
The iShares Core S&P Mid-Cap ETF (NYSEARCA:IJH) covers the sort of businesses that America would have been defined by before the emergence of the massive technology sector. The ETF is highly diversified with 404 holdings, so sectoral comments and general economic outlook will be key to thinking about the dynamics of this ETF. We think this industrial slice of America is a not compelling at the current earnings yield. There isn’t the sort of growth like in tech to justify the multiple in the face of risks, even if the outlook is not unambiguously weak. Benchmark rates are too high to be interested.
Breakdown
The ETF is highly diversified and there’s no special skew to individual stocks. The following are the sectoral exposures.
IJH Sectoral Exposures (iShares.com)
There are a lot of industrial exposures and consumer discretionary, which are not going to be the most resilient. Moreover, the financial exposures are under some pressure from the borrowers’ side, since a relatively leveraged US economy is more likely to see pressure on borrowers as rates stay high or go higher.
Consumer discretionary is going to lack resilience in a downcycle. While unemployment and GDP are holding fast in the US, we are still not entirely sure what is going to happen on the economic front as the lagged effects from higher rates kick in, and as the Fed decides how it is going to approach the last leg of inflation, which is likely to be more stubborn than the previous leg of declines which were helped by base effects and other factors. Likewise, recessionary pressures are beginning to reflect on industrial prices globally, and in commodities and products that lie just one level downstream from commodities, deflation is already in effect.
The matter of deflation in producer prices is critical considering that producer prices have paid the price from higher rates not consumer prices. In particular, stubborn rental rates are keeping consumer prices too high to give producer prices reprieve with a halt in the rate hikes. That is a shoe that must drop before the more commodified strata of US manufacturing can be confident that their industries will not enter into a meaningful recession
Bottom Line
With rent inflation being the main obstacle before eventually seeing more supporting inflation figures, there are positive signals pointing to an imminent decline in rent inflation. Residential housing markets have overperformed, but there has been a slowdown in growth in the asking rents based on Zillow (Z) data. Their incremental contribution to inflation figures could sharply diminish.
Still, there is a risk that in being insistent on the 2% target for inflation policy, and with the fact that there are surely many economic actors trying to nickel-and-dime each other with retaliatory price increases, interest rates pressures on the economy grow further or stay at uncomfortable levels for longer. The combination of producer price pressures and volume declines could have nasty scale effect for industrial companies, and the full burden of higher rates on interest expenses are surely not reflected in current run-rate financials, with maturity walls in 2024 and 2025 posing a potential problem for earnings growth over the next couple of years. IJH is going to have more indebted entities than the broader US market, as technology debt loads also tend to be lower.
With a 13x PE, the earnings yield is not that high compared to growing benchmark rates considering the potential pressures on earnings growth, and we believe current valuations are dependent on faster than expected declines in interest rates and rents. Markets are looking overly speculative in the US. Industrial exposures come much, much cheaper in Japan and are benefiting from a weaker Yen. Those seem to offer better risk-reward, but you can’t get them in an ETF with costs as low as the 0.05% expense ratio on IJH. Still, the earnings yield differential makes them more attractive, even when choosing ETFs.
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