EWG ETF: Germany Is Caught In A Perfect Storm (NYSEARCA:EWG)

For the second time in its modern history, Germany was recently “awarded” the title of “the sick man of Europe”. Indeed, there are plenty of headwinds the German economy is currently facing: high energy costs, declining competitiveness of the German industry, overwhelming bureaucracy, and so on.

With the exhaustion of the existing economic model, Germany will have to go through a painful period of adapting to a rapidly changing global economic landscape. Thankfully, Germany seems to have enough economic capacity to withstand the challenges.

If you’re looking for the most liquid and well-diversified Germany ETF, then iShares MSCI Germany ETF (NYSEARCA:EWG) is your way to go. However, the near-term economic prospects look frankly bleak, thus I’d give a pass for German equities for now. I assign a “Hold” rating to EWG at this time.

EWG ETF Overview

The iShares MSCI Germany ETF aims to track the investment results of an index composed of German equities. The EWG ETF is well diversified across sectors, though pretty concentrated in its holdings structure.

While the EWG ETF includes 68 companies, top-10 holdings comprise more than 56% of the overall holdings share.

Compared to other ETFs, the EWG has a relatively high expense ratio of 0.50%. However, EWG’s assets under management are superior to any alternative Germany ETF, which ensures the highest liquidity relative to peer funds.

EWG has demonstrated a comparable YTD performance of 15.53%, on par with FLGR, HEWG, and DAX. At the same time, HEWG and DAX ETFs have greatly outperformed EWG over the last five years, an important consideration for long-term investors.

German Economy Needs A Massive Overhaul

If you haven’t followed what’s going on in Germany, let me do a recap.

Germany’s growth is expected to be the lowest of any G7 country in 2023. German economic model with strong manufacturing and focus on export industries is struggling for several reasons:

• The Russian aggression in Ukraine has led to disruption in the economic ties between Germany and Russia, which made the German industry uncompetitive due to high energy costs. In one of the recent Financial Times pieces, the CEO of Salzgitter steel producer has warned that Germany is facing a creeping deindustrialization because of prohibitive energy expenses. Reuters reports that according to a survey by the German Chamber of Industry and Commerce (DIHK), almost a third of the surveyed German companies were planning to invest more abroad over the next 12 months.
• Germany faces declines in exports due to high exposure to China. The share of Germany’s exports to China has declined from a peak of 7.9% in 2020 to just 6.8% in 2022. That’s unsurprising given the fact that the Chinese economy itself is suffering from an economic slowdown.
• Germany’s aging population and workforce represent a demographic challenge. Germany may lose up to 7 million workers by 2035 without sufficient immigration or increases in workforce participation.
• Germany’s government and bureaucracy have not adapted well to the digital age, with slow digitalization of state services. This makes it harder for businesses to be productive, which leads to slower economic growth.

Moreover, German banks have low profitability compared to EU averages. The Economist cites the European Banking Authority, which estimates that in 2023 weighted-average return on equity of German banks was 6.5%, compared with 10.4% across the EU. As The Economist further explains, this is partly due to German banks’ focus on fixed-rate loans and lack of benefit from rising interest rates.

Is there a glimmer of hope for Germany? I’m definitely not in a pessimist camp, so let me provide some points why it’s not all that bad for Germany:

• Germany’s debt-to-GDP is 64.6%, a relatively comfortable level that provides the country with the required financial durability for overcoming the existing issues, especially in the government finally rules out an increase in public deficit.
• An influx of potential workforce from Ukraine may help to reduce the labor force shortages in Germany. Nearly half of Ukrainians who arrived in Germany since the Russian invasion of Ukraine want to stay in Germany. While it’s not always easy to integrate refugees into the economy, with proper regulation and tuning state support this aspect can be resolved, in my view.
• In my opinion, a post-war, post-Putin Russia will likely be interested in restoring economic relations with the EU and Germany in particular. While I don’t see such a prospect in the next 1-3 years, in the longer term everything is possible, in my view. Diversifying the energy supply of oil and gas between the US, the Middle East, and Russia may help the German industry to bring back global competitiveness.

To my mind, adapting to the new economic conditions will be certainly hard, but not impossible for Germany. As for stocks, I expect the mixed performance of German equities in the foreseeable future, as the current issues may weigh down on the profitability and growth of German companies.

Why To Pick And Why To Avoid The EWG ETF

Why To Pick:

• The oldest and the most liquid Germany ETF;
• Provides a diversified exposure to German stocks;
• Offers a modest yet helpful dividend yield of more than 2% on top of capital gains.

Why To Avoid:

• The expense ratio is high relative to peer Germany ETFs;
• The German economy may underperform over the next few years;
• Structural changes in the German economy may lead to mixed outcomes for German companies.