The close relationship between developing-world equity markets and the S&P/TSX Composite index is beginning to break down. This is either a very good thing, or a sign of trouble ahead for domestic equities.
In September, the three-year correlation between the MSCI Emerging Markets index and the S&P/TSX Composite was extremely high, with an R-squared of 0.70. The chart below shows that the correlation is steadily breaking down – the R-squared is now below 50.
One interpretation of the recent divergence is that, like Monty Python's parrot, the close relationship between Canadian and emerging markets equities isn't dead, it's just stunned. This view assumes that the correlation will resume, with either a big jump for developing world markets, a big drop in the TSX, or some combination of the two.
S&P/TSX Composite Index vs MSCI Emerging Markets Index
SOURCE: Scott Barlow/Bloomberg
There are two reasons to believe, however, that the ties between the MSCI EM index and the TSX are done for a while. Firstly, the divergence began in May, when Fed chairman Ben Bernanke issued his first warning about tapering. We are now in a different interest rate environment, where ten-year bond yields are about 100 basis points higher than before, in both Canada and the United States.
The new rate environment is less friendly to commodity prices than the old one. Since materials stocks were the reason that Canadian and EM equities were moving together, we can expect lower correlations between the two indexes, at least as long as rates remain elevated. Higher real interest rates in the U.S. support the value of the U.S. dollar, and since commodities are priced in greenbacks, they are less likely to rise.
The second reason to believe the EM/TSX link may be finished is that mining and energy stocks have had a much smaller effect on overall S&P/TSX performance. In the twelve months ending in May 2013, four resource stocks (Barrick Gold, Goldcorp, Canadian Natural Resources and Teck Resources) accounted for 320 (negative) points of benchmark performance. In the seven months since, the same four stocks have had a net effect of 7.6 points.
Domestic benchmark performance is now driven primarily by financial stocks, which are largely unaffected by conditions in emerging markets. Royal Bank and TD alone have contributed 238 upside points to the TSX since May.
The remarkable decade-long run where Canadian equities tracked the emerging markets index appears to be over. At the very least, developing markets equities are no longer a reliable indicator for domestic stocks.
Scott Barlow