Here’s why the TSX is getting hit by emerging markets turmoil

The recent volatility in emerging-market equities provides a very real risk to Canadian equity portfolios if it intensifies beyond Turkey, in light of the historically close relationship between the S&P/TSX Composite and the MSCI Emerging Markets Index. This is particularly true for investors in the energy sector and the oil price will be a key market indicator in the coming weeks.

The accompanying chart illustrates the value of $10,000 invested in both the S&P/TSX Composite and MSCI Emerging Markets Index in August, 2011.

From the beginning of the data until February, 2017, the performance of the two indexes was remarkably similar. There are two basic reasons for this. One, the obvious factor is the U.S. dollar. Domestic and developing world assets benefit from foreign investment flows when the greenback is falling and are adversely affected when the U.S. dollar climbs.

Global demand for commodities is the second reason for the TSX’s relationship with the MSCI Emerging Markets Index. In general terms, economic growth in the developing world is far more dependent on resource-intensive sectors such as infrastructure development and manufacturing than in the services-oriented economies of the developed world.

The Canadian economy is predominantly services-driven and modern, but the S&P/TSX Composite Index, with its 31-per-cent weighting in energy and materials, is more sensitive to changes in resource demand than virtually any other developed-world benchmark. When emerging market economies are strong, commodity demand and spot prices climb and this also pushes the domestic equity market higher.

So if the connection between developing world and Canadian equities makes sense, why did it break down in early 2017? As Bloomberg’s Luke Kawa recently pointed out, the emerging-markets index has issues similar to those the S&P 500 faces with FANG stocks (those of Facebook Inc., Amazon Inc., Netflix Inc. and Alphabet Inc.'s Google subsidiary).

In the same way that FANG stocks have determined the bulk of S&P 500 returns, three Asian technology companies – Baidu Inc., Alibaba Group Holding Ltd. and Tencent Holdings Ltd., known as BAT stocks – have recently come to dominate returns for the MSCI Emerging Markets benchmark.

The S&P/TSX Composite Index has no comparable companies to either FANG or BAT, and market performance has diverged as technology stocks surged. Importantly, while the TSX and the emerging-markets indexes have diverged, the developing-world economies remain vital to domestic equity performance. Emerging world growth, notably China’s, is the primary determinant of commodity demand and prices.

Emerging-market equity performance is less useful for Canadian investors as an indicator, but developing-world economic growth remains important. The International Energy Agency estimates that India and China alone will account for almost half of the world’s increase in crude consumption. OECD countries, which accounted for more than 70 per cent of global energy demand in the early 1970s, now account for 48 per cent as oil consumption growth becomes a developing-world phenomenon.

The current market focus is on Turkey’s public financial stress and the subsequent 27-per-cent drop in the value of their currency against the U.S. dollar since July 23. More broadly, however, emerging-markets currencies have weakened consistently in recent months. The MSCI Emerging Markets Currency Index has fallen 11.4 per cent against the greenback since early April. With oil valued in U.S. dollars, crude gets more expensive for developing countries as local currency values depreciate, threatening demand and the longer-term consumption growth path.

The biggest risk for investors, domestic and worldwide, is that pessimism spreads from Turkey throughout the emerging-markets countries, creating investment outflows that threaten economic growth. And, with the future of crude demand closely tied with developing-world growth, oil prices are likely the best way for investors to measure market fears of contagion and rising global equity and commodity price risk.

Scott Barlow, Globe Investor’s in-house market strategist, writes exclusively for our subscribers at Inside the Market.