Is The Spain ETF (EWP) Doomed?

by on May 28, 2010 | Updated June 4, 2010 | ETFs Mentioned:

Europe continues to steer global equity markets in 2010, as stocks around the world have taken their cues from a bloc of developed economies teetering on the brink of a sovereign debt crisis. As a crisis born in the shadow of Mount Olympus threatens to spread throughout the euro zone, governments have taken drastic–and often unpopular–actions to prevent the collapse of the common currency and minimize the drag on global growth (see Two “Anti-Euro” ETF Plays).

While Greece has dominated the headlines in recent months, investors long ago turned their attention to larger European economies that some fear could become the next domino to fall. A bailout of Greece would certainly be affordable for the more stable economies of Europe and the IMF. But Greece is not alone in its dire fiscal straits; in many ways Spain is already in much worse shape, and could create a much stronger drag on global markets if a crisis isn’t averted (see Why The Greek Bailout Only Delays The Inevitable).

Spain’s economy, which has historically relied heavily on the construction sector, plummeted in recent years when new building halted and real estate markets imploded. But unlike much of the developed world, the hangover from the recent recession is yet to fade in Spain, where hurdles to growth are both numerous and significant. Unemployment in Spain now exceeds 20% and is expected to hit 22% this year. Among youths, the jobless rate is even higher–by some estimates around 40%. With tax revenues sliding and spending on social services rising, Spain’s budget deficit is among the largest in the world.

The Spanish financial sector is showing signs of the stress. The central bank recently launched a takeover of Church-controlled savings bank CajaSur, firing senior management in the process. CajaSur is a relatively small institution, but the near-collapse spooked investors concerned about the ramifications of a wave of bank failures in coming months. The International Monetary Fund warned that Spanish banks need to speed up their restructuring following an annual visit to the country. “The Bank of Spain should be prepared to intervene promptly if pockets of weakness remain,” the IMF said.

Nation Divided

Investors cheered reports this week that budget cuts proposed by Spanish Prime Minister José Luis Rodríguez Zapatero survived a parliamentary vote; the package would cut an additional 15 billion euros in spending, an amount that would reduce the country’s deficit by an additional 1.5 percentage points of GDP over the next two years. But the razor thin margin by which the measure was approved–it passed by a vote of 169 to 168–shows that lawmakers are divided over how to best address the country’s rapidly deteriorating economic situation. At least one smaller party abstained from Thursday’s vote and demanded that Zapatero call early elections, further weakening the authority of the current administration.

Although seemingly effective plans have been proposed, debated, and approved, many analysts are skeptical of the divided government’s ability to follow through. The budget cuts are, not surprisingly, unpopular with many Spanish citizens; major Spanish unions warned on Thursday that they may call a general strike, a move that would complicate the implementation of proposed austerity measures.

Hope For The Spain ETF

The iShares MSCI Spain Index Fund (EWP) has been pummeled in recent weeks as concerns about Spain’s fiscal health build. After rallying on Thursday EWP is now down nearly 30% on the year and 15% over the last four weeks, making it one of the worst-performing equity ETFs over that period. But despite the string of negative developments, EWP isn’t necessarily a sinking ship.

EWP tracks the MSCI Spain Index, a benchmark that consists of the largest and most liquid stocks listed on Spanish stock exchanges. As such, many of the underlying stocks are mega-cap companies that generate significant portions of their revenues outside of Spain. The fund’s top two holdings, financial giant Banco Santander and Telefonica, are excellent examples. Both maintain significant operations in South America, and expansion in Brazilian markets has been a major component of revenue growth in recent years.

So while EWP will certainly be impacted by upcoming policy decisions in Madrid, it will also reflect the health of South American markets; this ETF isn’t a “pure play” on the Spanish economy (see What Every Investor Must Know About The Spain ETF).

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Disclosure: No positions at time of writing.