Canada is home to a proudly modern, diversified economy that is also attached to a currency and equity market that resembles a developing country far more than any other member of the G7. This is not a good thing in the midst of a major sell-off in the emerging markets.
The U.S. election was the catalyst for a 5.9-per-cent drop in the MSCI emerging-markets index, in U.S. dollar terms. The president-elect's anti-trade campaign rhetoric – including a pledge to wall off Mexico and slap a 35-per-cent tax on Chinese imports – caused immediate selling pressure throughout the developing world.
The Canadian dollar and asset markets followed lower – and not just because Donald Trump vowed to "tear up" the North American free-trade agreement. Economic optimism regarding the new administration's planned $1-trillion (U.S.) infrastructure spending initiative resulted in a rise in future U.S. economic growth expectations, which pushed U.S. bond yields and the U.S. dollar higher.
The loonie and the MSCI index are priced in U.S. dollars, so their values both dropped when measured in that currency. In addition, markets were reflecting the potential for trade sanctions to depress economic growth in the developing world. Emerging economies are resource intensive, using more commodities per unit of gross domestic product growth than in the developed world, and slower growth would mean lower commodity exports that would eventually depress Canadian energy and mining company profits.
The first chart below depicts the close relationship between emerging market currencies and the loonie. The emerging-market index has been more volatile, but has consistently moved in the same direction as the dollar during the past five years. In recent days, a divergence in the chart – emerging-market currencies were significantly outperforming the loonie – was mostly resolved by a sharp fall in developing world currencies.
Global bond markets are likely playing a large role in foreign exchange market volatility. Previously, it was common for hedge funds to borrow U.S. dollars at low rates and buy high yield government bonds from, for example, Russia (while hedging currency risk).
The post-election surge in the greenback, however, is making the loans more expensive to repay. Speculative investors are unwinding their positions as a result – selling emerging-market bonds and exchanging the proceeds into U.S. dollars to repay the loans. This has created a temporary downward spiral in both developing world bonds and currencies.
Using the iShares MSCI Emerging Markets ETF (converted to Canadian dollars), the second, lower chart reviews the extremely high correlation between the S&P/TSX composite and emerging-markets equities for the past five years.
The future course of both charts is susceptible to every public utterance of a U.S. president-elect who appears simultaneously volatile and vague about the details of future economic policy. Even the infrastructure plan that has roiled equity and bond markets is no sure thing – there is considerable political opposition from within his own party in Congress.
The election result was a surprise, emotions were high and the result was an explosion in market volatility. I strongly suspect that some of these price moves, copper's surge and bond market weakness for instance, are overdone and will be partially retraced in the very short term.
In the mid-term, I don't even want to guess without more information – I think a lot of us have learned a lesson about that recently.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market.