Time to be Cautious With Australia ETFs?

As Australia's S&P/ASX 200 index has surged 16 percent over the past 12 months, equity-based ETFs tracking the worlds 12th-largest economy have predictably benefited.

The iShares MSCI Australia Index Fund (NYSE:EWA), the largest ETF tracking the country, is up about 14 percent in the past year while the WisdomTree Australia Dividend ETF (NYSE:AUSE) is more than 16 percent.

The IndexIQ Australia Small-Cap ETF (NYSE:KROO) has started to impress recently, surging 11.3 percent in the past 90 days. That all sounds good, but as iShares Global Chief Investment Strategist Russ Koesterich notes, there are some causes for concern down under.

In a recent note, Koesterich reiterated his near-term neutral view of Australian equities, but added he is "closely watching the market for a possible downgrade."

One reason Koesterich gives for possibly downgrading Australia is frothy valuations. EWA currently sports a P/E ratio of 18.7 and a price-to-book ratio of 2.61, according to iShares data.

"Australian equities are trading for nearly 2x book value. While this represents a discount to US stocks, Australia is now trading at a premium to most developed markets," said Koesterich.

The iShares MSCI German Index Fund (NYSE:EWG), iShares MSCI Singapore Index Fund (NYSE:EWS) and the iShares MSCI Japan Index Fund (NYSE:EWJ) all have lower price-to-book ratios than EWA.

While the financial services sector accounts for over 48 percent of EWA's weight, that ETF is heavily exposed the materials sector with an allocation of almost 22 percent. Mining giants BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO) are both among the ETF's top-10 holdings. Australia's status as a major raw materials exporter not only exposes investors to commodities prices, but to currency fluctuations as well.

On that note, the Australian dollar has been persistently strong against its U.S. rival, providing headwinds for Australian exporters.

However, a willingness by the central bank there to pare interest rates has not stemmed the tide of the rising Aussie and the outlook for Australian monetary policy could be seen as complicated in the near-term.

"Australian monetary policy has become complicated by the fact that the country's mining sector is growing at a very different rate than the rest of the economy," said Koesterich. "After an aggressive round of rate cuts, the RBA is now taking a pause to determine if its recent policy easing will be sufficient to ensure a pickup in the non-mining sector."

Mining sector issues imply the Australian economy needs some help from other industry groups, something it has yet to receive in earnest. Should that scenario come to fruition, investors should give AUSE a look because that ETF devotes about a third of its weight to consumer-related stocks.

Overall, Koesterich holds a favorable view of Australia for the patient investor, citing the country's "exceptionally low debt burden, a budget close to balanced, a profitable corporate sector and a sustainable pension system."

However, lofty valuations, sluggish mining sector growth and consumer debt burdens are issues that could hamper Australian stocks and the corresponding ETFs in the short-term.

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