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Amid Signs of Slowing Growth, Koesterich Downgrades Germany

Amid Signs of Slowing Growth, Koesterich Downgrades Germany

Germany, the Eurozone's largest economy, has long been a beacon of light in an economically troubled region and investors' confidence in German equities has been rewarded this year. The country's benchmark DAX is one of the best-performing major indexes in the world while the iShares MSCI Germany Index Fund (NYSE: EWG) has surged 28.2 percent.

However, there are signs the German economy is slowing. As such, BlackRock Global Chief Investment Strategist Russ Koesterich has pared his view on Germany to Neutral from Overweight. Koesterich points to a recent slide in German retail sales as one indicator the economy there is slowing.

"The most recent reading for German retail sales was a drop of 3.6%. With retail sales collapsing, German consumer discretionary companies, which comprise the biggest weight in the index, may disappoint in the coming quarters," said Koesterich in a blog post.

Indeed, a potential decline in consumer discretionary shares could be problematic for Germany ETFs. The aforementioned iShares MSCI Germany Index Fund, the largest Germany ETF by assets, allocates almost 18.5 percent of its weight to discretionary names.

EWG is not alone in terms of large weights to German discretionary stocks. The First Trust Germany AlphaDEX Fund (NYSE: FGM) holds a 26.6 percent weight to that group. FGM debuted in February and has since returned 9.3 percent. The Market Vectors Germany Small-Cap ETF (NYSE: GERJ) has a 16.6 percent weight to the discretionary sector. GERJ has surged 30.4 percent year-to-date.

Another issue to consider, Koesterich notes, is valuation. As in German equities were once cheap, but that is no longer the case.

"The price-to-book ratio now stands at 1.53. While this is still cheap compared to the United States, it is up considerably from a year ago, when it was 1.27, and is increasingly expensive compared to other European markets," said Koesterich.

EWG currently has a price-to-book ratio of almost 2.2, according to iShares data. That is well above the 1.51 price-to-book sported by the iShares MSCI Austria Investable Market Index Fund (NYSE: EWO) and the 1.76 price-to-book on the iShares MSCI France Index Fund (NYSE: EWQ), just to name a pair.

FGM appears to be more reasonably valued than EWG with a price-to-book ratio of just 1.25, according to First Trust data. In what may be a surprise to some investors, GERJ's exposure to German small-caps has not led to a rich valuation despite the ETF's stellar run higher this year. That ETF has a price-to-earnings ratio of 11.24 and a price-to-book ratio of 1.43.

Overall, Koesterich said he still likes Germany's long-term fundamentals, but he advises waiting for a pullback to buy this market.

":onger term I still like the fundamentals of Germany, which is distinguished by its world class industrial and export sectors. And I would look to re-enter the market on a pullback, or on signs of stabilization in the German economy. However, in the near-term I would favor taking some profit and adopting a neutral stance on German equities," he said in the note.

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