TSP

UK makes up 17% of I Fund and the IMF estimates that a no-deal Brexit scenario would result in a 6% negative impact to the UK’s GDP.

By: Lyn Alden

The I Fund, which includes over 900 foreign companies and currently follows the MSCI Europe, Australasia, Far-East (EAFE) index, is down almost 9% year-to-date in 2018.

Here’s a chart of an equivalent fund:

Chart Source: Google Finance

The main thing that’s in the favor of the I Fund is how fundamentally cheap it is compared to the C Fund and other U.S. stock indices. With an average price-to-earnings ratio of less than 14, and a price-to-book ratio of less than 1.6, the I Fund is arguably undervalued at this point.

In contrast, the C Fund has a price-to-earnings ratio of over 22, and a price-to-book ratio of over 3.2. In other words, investors are paying a lot more money for each dollar of earnings and company book value (assets minus liabilities) for U.S. companies compared to their foreign counterparts in similarly developed countries.

Exactly what the valuation should be is hard to say, but a large portion of these low valuations for I Fund companies are deserved. The economies of Japan and Europe, where most I Fund companies are located, are growing more slowly than the United States. The index also has considerably lower exposure to technology stocks than the United States, mainly because the whole of Europe has a much smaller technology market. The large allocation to technology stocks in the U.S. tends to skew their valuation numbers higher.

Japan makes up about 24% of the current I Fund and the United Kingdom makes up another 17% of it. These two countries alone make up over 41% of the 21-country index, and both of them have trouble on the horizon.

Japan: Economic Malaise and Trade Troubles

Japan has a shrinking population that is also very top-heavy. Their shrinking working-age population has to support their growing number of very long-lived elders. The country also has the highest government debt as a percentage of GDP in the world, at well over 200%.

Due to this, their economic growth rate is very slow. The International Monetary Fund (IMF) expects Japan’s real GDP to grow at well under 1% per year from now through 2023.
The country has been trying to boost their economic growth, and even trying to boost their inflation to a target of 2%. Japan’s shrinking and aging population has been deflationary on the currency, so despite their attempts, the Japanese central bank has not been able to attain its inflation goals.

For example, the Bank of Japan is the most aggressive user of quantitative easing (QE) in the world. Over the past five years, Japan’s central bank balance sheet has more than tripled in size as the bank keeps buying bonds and even stocks:

Chart Source: Trading Economics

Within the past month, the Bank of Japan’s balance sheet became larger than the country’s annual GDP. In comparison, the U.S. Federal Reserve’s balance sheet is only about one-fifth as large as U.S GDP.

This is a rather unconventional and unprecedented monetary situation for Japan with such massive central bank asset-buying.

In addition, Japan’s economy shrank last quarter, partly due to bad weather but also due to decreased exports to China. China is Japan’s largest trading partner, and so any slowdown in trade between the U.S. and China also impacts Japan.

United Kingdom: Brexit Deal in Question

The news that dominates the UK market is their eventual separation from the European Union, commonly referred to as “Brexit” – with a potential negative impact on the UK’s GDP.

In the summer of 2016, citizens of the UK voted in a referendum to leave the EU. Since then, there have been intense negotiations been authorities from the UK and EU for how to have an orderly separation, since the union includes various policies ranging from immigration to customs to trade and more.

Last week, the UK cabinet finally approved a draft withdrawal agreement. However, the contents of the agreement were immediately criticized across the political spectrum as being unfavorable to the UK, and the prime minister’s own Brexit Secretary abruptly resigned from his position due to his opposition of the agreement.

The UK prime minister, Theresa May, plans to hold a vote on the draft withdrawal agreement in the House of Commons. The outcome is uncertain, however, because many within May’s own political party disagree with the agreement, in addition to general disagreement from her primary opposition party.

One of the most significant risks is that the UK could end up leaving the EU without any formal agreement in place, which would mean no immediate free trade agreements between the UK and the EU, among many other issues. The IMF estimates that a no-deal Brexit scenario would result in a 6% negative impact to the UK’s GDP.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.