The stodgy Bureau for International Settlements notes that fixed income investors are increasingly fleeing emerging markets despite higher yields relative to the developed world. Emerging market bond prices are falling as investors depart which causes weakness in local currencies and returns for emerging markets assets as a whole.
For Canadian investors, the trend is highly relevant to portfolio returns. The past decade has seen the S&P/TSX composite index move in virtual lockstep with the MSCI emerging markets index (of equities) once the value of the loonie is taken into account. The weakness in emerging markets can easily translate to declines in the domestic equity benchmark.
Capital flight has been particularly severe in the energy producing developing countries of Malaysia (second-largest oil and gas producer in Southeast Asia) and Angola (the second-largest energy provider in sub-Saharan Africa). The connection between the recent weakness in domestic energy stocks and the performance of these emerging markets underscores the close relationship between Canadian equities and the developing world.
The chart below tracks the amazingly tight relationship between the TSX composite and the MSCI emerging markets index, converted to Canadian dollars, over the past decade (using weekly data).
SOURCE: Source: Scott Barlow, Bloomberg
The one-year period after October, 2013, saw the TSX outperform the MSCI index by a significant margin. This raised hopes that the correlation was breaking down, and that Canadian equities were less dependent on the resource-hungry emerging markets and were reflecting some positive effects from an acceleration in the U.S. economy.
The oil selloff, unfortunately, brought the domestic market back in line with developing world equities.
In a perfect world, I'd be able to use this chart to provide at least loose guidance on the future direction of Canadian equities, but I can only speculate. The re-connection of the TSX/MSCI emerging markets index implies that the domestic market could be dependent on developing world growth and commodity demand. In that case, the success of the Chinese government stimulus efforts – which reports indicate might include quantitative easing – will be all-important.
A quicker U.S. economic recovery is the other positive scenario that would break the long-term trend on the chart and see domestic equities outperform emerging markets. In that instance, new sector leadership would appear in the S&P/TSX composite with companies like Magna International Inc., Linamar Corp. and retailers benefitting from rising exports and manufacturing activity in populous central Canada.
Follow Scott Barlow on Twitter @SBarlow_ROB.