EZU iShares MSCI Eurozone ETF

As 2012 has progressed, investors have been broadly spared from the turmoil in many European markets. The PIIGS have managed to keep their crises in check and stock markets have largely gained on the lack of negative news, putting last year’s slump firmly in the rear view mirror.

Yet while things have gone pretty smoothly so far this year, we could be seeing a reversal to this trend here in the second quarter. This shift looks to be due to the trillion dollar economy of Spain and the impact that this enormous nation could have on the broad euro zone and global growth at large (see more at the Zacks ETF Center).

This could be due to growing investor trepidation regarding the Spanish bond market, especially after the auction earlier this week. In the issuance of medium term debt, the country sold just over 2.5 billion euros of notes, putting the offering at the low end of the 2.5 billion euro to 3.6 billion euro plan initially put out by the government.

To top things off, the Spanish Prime Minister, Mariano Rajoy, said that the country’s economic situation is one of ‘extreme difficulty’ and that the country may need to ask for a bailout like its peripheral counterparts have in months past. Given this rhetoric and the difficult time the country may have in engaging in more austerity, Spain might very well be in for some trouble later this year, potentially throwing a wrench into the broad recovery.

Thanks to this, the yields on benchmark 10 year Spanish government debt spiked by about 25 basis points, pushing rates just below the 5.7% level. This gain represented a 4.5% move in the session and is in sharp contrast to what investors saw in early March while yields were just below 5% (read Norway ETFs For Safer European Plays).

This pulled down European ETFs across the board with most products sinking by at least 2.5% on the session. Losses were surprisingly led by funds in strong nations such as Germany or the Nordic region, possibly due to perception that these countries will have to take the brunt of any possible Spanish bailout in the near future.

Nevertheless, it is not like the Spanish ETF (EWP) escaped the broader European ETF turmoil on the day either. The fund finished the day after the auction down about 2.8% on heavy volume which was nearly five times what investors see on a daily basis.

However, the losses haven’t been contained to this one trading session as the product has seen severe weakness for quite some time. In fact, the fund is down about 8.9% in year-to-date terms while the European ETF has lost about 35.9% over the past 52 weeks (see Three European ETFs Beyond The Euro Zone).

This performance is also in sharp contrast to not only broad European ETFs but to other country specific funds as well. In fact, the broad Euro Zone ETF (EZU) has added about 8.2% in year-to-date terms while the still new Greek ETF (GREK) has gained 2.7% in the time period in question.

As a result of this broad underperformance of EWP when compared to its counterparts in the region, investors should start to wonder if the product could be the next shoe to drop in the European debacle. After all, it cannot be good news when the Spanish ETF is underperforming other PIIGS funds by such a wide margin to start 2012.

Another reason for worry is EWP’s heavy exposure to financials. The ETF allocates nearly 41% of its portfolio to the sector with the vast majority going towards the broad banking industry. Given that financials are among the worst places to be when fears of a default are high, investors shouldn’t be surprised to see that this ETF has struggled so far in 2012 (read German ETFs On The Rise).

This is especially true when looking at some of the fund’s biggest individual holdings. For example, Banco Santander (STD), which makes up nearly one-fifth of the total assets, is trading perilously close to its 52 week low having posted a loss of nearly 14.3% in the past month alone.

So, given the heavy focus on banking in EWP and the increasingly uncertain Spanish economy, most investors may want to stay out of the fund at this time. The product is grossly underperforming the rest of its PIIGS brethren and could now be poised to be the leader on the downside in the near term (see Italian Bond ETFs: High Risk, High Reward).

Thanks to these trends, the increasingly negative rhetoric from the Spanish government, as well as the lack of focus on small PIIGS like Ireland or Greece, and investors have a perfect storm in Spain this year. As a result, we could definitely see more losses in this volatile European ETF this year suggesting that if your portfolio contains a long position in EWP it needs to be monitored extremely closely now that the focus of the euro crisis appears to be zeroing in on Spain.

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