Canadian equity performance remains closely tied to emerging markets performance and, at this point, that's a very bad thing.
The accompanying chart is not good news for Canadian investors trying to convince themselves that China's economic and market struggles aren't important to the domestic equity market. The S&P/TSX composite index has maintained its close performance relationship with the MSCI emerging markets index once the developing world benchmark is converted to Canadian dollars.
Commodity prices and currency fluctuations play a big (and overlapping) role in consistently driving the two lines on the chart in the same direction. The largest country weighting in the MSCI index is China at 27 per cent of assets. China's 30-year economic miracle has seen the country become the largest source of demand for almost every commodity and up until recently, this benefited the large resource weighting in the Canadian benchmark. Domestic resource stocks have declined as China's growth slowed, and this trend accounts for a significant proportion of the connection between domestic and emerging market equity performance.
The U.S. dollar has also played a role in the close relationship between Canadian and developing world equities. U.S. central bank policy – by depressing the value of the greenback against both the loonie and emerging markets currencies from 2009 to late 2011, and driving it higher afterward – also helps explain why the two lines on the chart have moved virtually in tandem.
There was some hope in 2015 that domestic equities would be able to decouple from developing world markets as Canadian economic growth shifted from resources to southbound exports. This has yet to occur, leaving Canadian portfolios shackled to deteriorating economic conditions in Asia, Latin America and Africa.
Investors should remain cautious on domestic equities until the correlation on the chart breaks down. There are without question many stocks in the TSX that are unaffected by emerging markets, but the risk is they'll be "caught up in the wash" – pulled lower by poor market sentiment and general selling pressure.
It's also conceivable that the correlation between Canadian and emerging market assets remains high, and developing world equities recover and the TSX rises along with them. But with further signs that Chinese markets are slipping from government control and support, and the remainder of Asian economies dependent on the Chinese economy for growth (South Korean stocks make up the second-largest national component in the benchmark), a rally in the MSCI emerging markets index appears unlikely in the near future.
Follow Scott Barlow on Twitter @SBarlow_ROB.