Koesterich Downgrades Australia

Australia's economy, the world's 12th-largest, has dodged recession for 21 consecutive years and seems to be on firm footing. For investors, the environment for Australian equities and ETFs may not be as sanguine as it initially appears.

The iShares MSCI Australia Index Fund (NYSE:EWA) is up 15.2 percent in the past year, but over the past month, the largest Australia ETF has tumbled 3.7 percent indicating slack commodities demand among other factors may be hampering Aussie stocks.

With some obvious headwinds facing the Australian economy, iShares Global Chief Investment Strategist Russ Koesterich downgraded the market today from Neutral to Underweight.

Koesterich reiterated a neutral view of Australia in February, but warned at that time he was keeping close watch on the market for a possible downgrade.

"While Australia posted a strong fourth-quarter 2012 gross domestic product report, more recent local business confidence surveys are pointing to a slowdown in domestic growth," said Koesterich in a blog post. "At the same time, the economy faces future growth headwinds including a strong Australian dollar and easing commodity prices."

EWA's correlation to commodities demand and pricing is noticeable. The materials sector accounts for nearly 19 percent of the ETF's weight, trailing only financials at 50.4 percent. BHP Billiton (NYSE:BHP), the world's largest mining company, is EWA's second-largest holding at a weight of 10.3 percent. EWA has risen nearly 150 percent since bottoming in February 2009, a move helped in large part by a pickup in commodities demand.

However, EWA's track record indicates a high level of sensitivity to goings on in China. For example, 2011 was a tough year for Chinese stocks and the iShares FTSE China 25 Index (NYSE:FXI) fell 17.6 percent. EWA fell 11.7 percent, not surprising as China is Australia's largest trading partner. Then there is the matter of valuation.

"Australia's sluggish growth outlook is problematic given that local equities are expensive compared to those of other developed markets," said Koesterich. "While most market watchers have been focused on the United States rally lately, Australia has actually done better over the last 12 months. Since March 2012, Australian equities have climbed roughly 16% in dollar terms, outpacing most developed markets, including the United States."

While the Reserve Bank of Australia went on a scorched earth campaign of interest rate cuts that started in late 2011 and lasted through late 2012, the central bank has recently signaled it will hold off on further rate cuts. Australia's overnight cash rate is three percent, low by that country's standards but high compared to much of the developed world.

High interest rates and a credit rating of AAA have increased the allure of the Australian investment thesis while stoking demand for Australia dollars. The Aussie has been the best-performing developed market currency against the U.S. dollar since the financial crisis, but that is not good news for Australian exporters. As Koesterich notes "future growth headwinds including a strong Australian dollar and easing commodity prices."

EWA, which is home to $2.55 billion in assets under management and an expense ratio of 0.51 percent, has a P/E ratio of 19.23 and a price-to-book ratio of 2.63, according to iShares data. The ETF is up about four percent year-to-date.

For more on ETFs, click here.