Post-Brexit, Banks Could Be Problems For U.K. ETFs

Underscoring the vulnerability of U.K. assets in the post-Brexit world, the Guggenheim CurrencyShares British FXB is lower by nearly 12 percent over the past month. Remembering that when an investor opts for international stocks or funds he or she not only incurs equity risk, but currency risk as well, it is worth noting the iShares MSCI United Kingdom ETF (iShares Trust EWU) is lower by 6.5 percent over the past month.

Brexit, The Pound And U.K. Equities

Prior to the official Brexit outcome, the notion of Great Britain's departure from the European Union was widely seen as pound negative, a thesis that has been proven. Brexit was also seen as potentially challenging for various U.K. equity sectors.

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“More than one-in-three companies report that uncertainty over the outcome of the EU referendum is having a detrimental effect on their business. One-in-twelve firms report a strongly detrimental impact,” according to Markit.

Historically, EWU is not a volatile ETF. The fund has a three-year standard deviation of just 14.6 percent and allocates 30.5 percent of its weight to lower beta consumer staples and healthcare names, a trait that pumps the ETF's dividend yield north of 4 percent.

However, already strained U.K. financial services firms are also seen as vulnerable post-Brexit. That could be problematic for EWU because financial services is the ETF's second-largest country weight at 19 percent.

“The outcome of the EU referendum will create a challenging macro-environment with negative implications for UK banks' domestic operations, says Fitch Ratings. The uncertainty following the referendum will result in an abrupt slowdown in near-term GDP growth, although we expect the impact to be manageable at the banks' rating levels. But ratings could be downgraded if the economic effect of Brexit is either protracted or particularly severe,” said Fitch Ratings in a recent note.

Looking Closer At EWU

EWU sports a tempting trailing 12-month dividend yield of almost 4.7 percent. That is high relative to other developed market single-country ETFs and high considering the U.K.'s low interest rates, which some market observers are betting could be trimmed at the Bank of England's August meeting.

The U.K. has been one of the best developed markets dividend destinations after the United States, but dividend growth in the U.K. has slowed amid a spate of cuts among banks and materials companies, sectors that combine for over a quarter of EWU's weight.

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“UK banks have been operating in a supportive environment for at least three years. Falling unemployment and prolonged low base rates have resulted in low volumes of new impaired loans. Banks have also taken advantage of the benign economic conditions and rising investor appetite to dispose of legacy non-core assets, and boosted the reserve coverage of older impaired loans. These have gradually weighed less heavily on balance sheets, so tail risk has reduced ahead of the anticipated economic slowdown,” added Fitch.