The accompanying chart never ceases to amaze me. The S&P/TSX composite index, the main equity benchmark for a proudly G7, highly developed economy, has moved almost exactly in tandem with the MSCI emerging markets index. A recent surge of global investment in emerging markets makes this relationship all the more important for Canadian investors.
A Merrill Lynch research report dated March 17 pointed to a sharp change in trend regarding emerging markets investments. It said global investors have yanked $164-billion (U.S.) out of developing world investments in the past three years, but recent weeks have seen a jump in investor interest.
The first two weeks of March saw $3-billion in new money allocated to emerging market equities according to Merrill Lynch. A separate report from Royal Bank of Scotland analysts estimated that almost $40-billion will have been invested in developing world bonds and equities during February and March – the largest amount since mid-2014.
The chart highlights why the new-found optimism in emerging markets could be very positive for domestic stocks. For the past decade, Canadian and emerging market equities have moved along almost identical paths. A rise in emerging market equities is likely to be accompanied by strength in the domestic market.
The interrelated factors behind the connection between Canadian and developing world markets make it likely that the pattern will continue. The U.S. dollar is the dominant driver of the similarity in performance – a falling greenback increases the value of Canadian and emerging-markets assets and the reverse is true when the dollar climbs.
The U.S. dollar also affects commodity prices, which form the other major reason domestic equities and the MSCI emerging markets index closely follow each other. Developing world economies, notably China's, use more commodities per unit of economic growth than in the developed world, where service industries drive the economy. Stronger expansions in the emerging world drive commodity prices higher, which benefits the still-considerable portion of companies in the S&P/TSX operating in the energy and mining industries.
In my opinion, the recent trend of strength in emerging market equities is more a "return of stability" than the beginning of a longer term trend of outperformance. The Federal Reserve has merely postponed interest rate increases that, when they occur, will almost certainly result in U.S. dollar strength.
It's also worth noting that Merrill's report said a significant portion of inflows to emerging markets was the result of large scale global investors going from underweight to equal weight in emerging market equities. In these cases, the portfolio managers are going from a bearish to neutral outlook, not getting blatantly optimistic.
Still, Canadian investors should welcome more market stability after a highly volatile 2015 and early 2016. And no matter what happens, domestic investors should pay close attention to sharp market moves in any direction in developing world equities.
Follow Scott Barlow on Twitter @SBarlow_ROB.