Will Tax Hikes Send Spain ETF Tumbling?

by on September 28, 2009 | ETFs Mentioned:

Over the weekend the Spanish government approved a 2010 budget featuring significant tax hikes to support increases in government spending. Spain has seen spending surge over the last year as the country attempts to avoid a prolonged recession that some analysts fear could result in a “lost generation” similar to Japan’s fate following the Nikkei bubble. Under the most recent version of the plan, the general VAT tax will increase from 16% to 18% in July, while the special VAT tax, which is applied to services, food production, and art, will rise from 7% to 8%.

Plaza De Castilla In MadridDespite these additional revenues, Spain is projecting a budget deficit equal to 8.1% of GDP. This is a moderate improvement from the previous projection of 8.4%, but is well above the 3% limit imposed by the EU for users of the euro currency. The European Commission has given Spain until 2012 to bring its deficit down to the 3% level.

Spain is one of Europe’s largest economies, and has been hit particularly hard by the economic downturn. The country’s construction industry, which accounts for a significant portion of GDP, has collapsed, sending the national unemployment rate as high as 17% and youth unemployment to a staggering 38%. The jobless rate in the total Euro zone is around 10%.

The Spanish government still claims that the downturn on the Iberian peninsula will be relatively moderate relative to the rest of Europe. But signs to the contrary are beginning to emerge. Madrid research group RR de Acuña & Asociados recently reported that the economy will contract for the next three years. The group anticipates a peak to trough loss of 11% of GDP, and sees unemployment rising to 25% before a recovery begins. At its current level of 1.6 million unsold properties, the real estate market could take six to seven years to clear.

Ambrose Evans-Pritchard traces Spain’s problems to monetary policy. “The root cause of Spain’s trouble is that it joined monetary union before its economy was ready,” writes Pritchard. “EMU halved Spanish interest rates almost overnight. Real rates were -2% for much of this decade.”

Not surprisingly, there are some very vocal critics of the government’s tax plan. Opposition politicians and independent economists believe it is too soon to begin increasing the tax burden on consumers, fearing that the additional burden to consumers will only deepen the recession.

Somehow, Spain ETF Surges

Despite the abundance of bad news and legitimate risk of the already severe recession becoming a full-blown depression, the iShares MSCI Spain Index Fund (EWP) has performed relatively well recently. EWP has surged more than 30% year to date, and has nearly doubled from its March lows. Although well below its all time highs, EWP is in the black over the last 52 weeks, a claim few equity ETFs can make. Somehow, Spain’s economy and the U.S.-listed ETF that seeks to track its stock market seem to be going in opposite directions.

The explanation behind this apparent contradiction is actually quite simple. EWP is diversified across 30 individual holdings, but the top two, Banco Santander and Telefonica SA, account for 42% of the fund. These companies are headquartered in Spain, but generate the majority of their revenues and earnings outside of Spain, limiting their exposure to their homeland.

Santander has operations in dozens of countries throughout Europe and Latin America. In the first half of 2009, Santander generated only about 27% of its profit from Spain, meaning that the company relies on foreign operations for a significant portion of its earnings. And unlike most financial institutions that have been crippled in the current economic environment, Santander generates most of its earnings from retail banking (nearly 70% in the first half of 2009). Because of its geographic diversification and focus on retail banking, Santander has seen very strong financial performance over the last year.

Telefonica SA is a leading telecommunications company that provides wireless, broadband, and other pay TV services throughout Europe and Latin America. Not surprisingly, Spanish operations were a drag on the company’s operations in the first half of the year (declines in revenue and OIBDA of 6.3% and 6.9%, respectively). But relatively strong results in Telefonica’s other operating regions have contributed to a strong overall bottom line. Telefonica’s stock price has actually jumped in the last year, making a big contribution to EWP.

So while the broad Spanish economy faces monumental challenges and a very uncertain future, EWP has delivered strong gains this year, attributable primarily to two companies.


The old saying “never judge a book by its cover” certainly applies to the world of ETFs. EWP is one of the best options available for U.S. investors looking for exposure to Spanish equities, but it isn’t nearly as diversified as many U.S. ETFs. EWP has a major tilt towards large cap equities (average market cap of $66 billion) and the financial sector (46% of holdings), and depends heavily on the performance of Banco Santander and Telefonica SA.

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Disclosure: No positions at time of writing.