Look closely enough, and this week's first chart summarizes a few thousand pages of financial theory on asset allocation. For Canadian investors, it implies a continued focus on U.S. equities and lower weightings in Canadian stocks.
SOURCE: Scott Barlow/Bloomberg
The left y-axis plots the relative performance of the S&P 500 and the MSCI Emerging Markets index by simply dividing one by the other. A rising line indicates that U.S. equities are outperforming developing world markets. The y-axis on the right measures the value of the U.S. Trade Weighted Dollar Index – the value of the greenback against the country's major trading partners.
The 30-year pattern shows that it is extremely rare for emerging markets equities to outperform when the trade-weighted U.S. dollar is rising. The factors driving this are numerous – cross border asset flows, U.S. Federal Reserve monetary policy (low rates definitely motivated emerging markets investment. The only real question is how much), relative bond yields, global investor risk tolerance…. The list could go on for another page.
It appears that we've entered a new cycle of dollar strengthening that began in 2011. This idea is supported by recent data from Europe and Japan showing rapidly slowing economies and significant deflationary effects. The trend in U.S. data has been strong, particularly in comparison to Europe and Asia, and this will attract foreign flows that strengthen the dollar further.
As long as the U.S. dollar rally continues, we can expect U.S. equities to outperform the MSCI Emerging Markets benchmark.
The second chart shows why this trend is so important to Canadian equity returns. The S&P/TSX Composite Index has moved almost in lockstep with emerging markets stocks in recent years. The domestic benchmark's relatively high weighting in resource stocks – which benefited tremendously from the infrastructure and construction booms in China and elsewhere – explain the close relationship.
MSCI Emerging Markets index vs S&P/TSX Composite (USD)
TSX indexed to 100 in Oct 2004
SOURCE: Scott Barlow/Bloomberg
The ongoing underperformance of emerging markets will likely be mirrored by TSX underperformance of the S&P 500 for as long as the strong dollar trend continues. Domestic investors can expect that portfolios with larger weightings in U.S. stocks will outperform an all-Canadian portfolio.
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