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The drubbing emerging markets have taken since last month would normally be really bad news for Canadian stocks.

There is, however, reason to believe that this time is different.

The S&P/TSX Composite Index and the MSCI Emerging Markets Index have historically been highly correlated once currency effects are backed out. There are two related reasons for this. One, developing world growth is resource intensive relative to the Group of Seven – each unit of GDP growth requires more commodities compared with the services-oriented developed world economies. So, when emerging markets are doing well, so are Canadian energy and mining stocks.

The second reason is currency related. A rising or falling U.S. dollar has a similar effect on the currencies of emerging markets and the loonie. The Canadian dollar is often driven by the oil and copper price, which is why the two drivers of correlation – commodities and currency – are interlinked.

The accompanying chart tracks the weekly value of $10,000 in both the domestic equity benchmark and the MSCI Emerging Markets index over the past 10 years. You’ll see that a major divergence began after the emerging markets index peaked in late February last year.

Based on the chart alone, I’d be very concerned that Canadian stocks were about to follow developing world equities lower. But the current investing backdrop is far from conventional. The 20-per-cent slide in the Canadian dollar value of MSCI Emerging Markets Index that began in February of 2021 has not been accompanied by weak commodity prices. Thanks to Vladimir Putin’s delusional foray into Ukraine, most major resource prices have spiked higher.

China’s growth path is almost of equal relevance to domestic portfolios. It is important to note that the divergence on the chart that began in early 2021 coincided with a Chinese government crackdown on technology giants including Baidu Inc. and Alibaba Group Holdings Ltd., which contributed to a decline in the emerging markets index.

Chinese technology stocks have little direct connection to the Canadian economy or stock market, but the country remains the primary driver of global commodity demand and prices. It is therefore rare that commodity prices are so elevated while China’s economic growth has slowed to 4 per cent, less than half of its 20-year average of 8.7 per cent.

A recovery in Chinese growth would add even more fuel to the raging commodity rally and support the TSX further.

The duration of the Ukraine conflict is clearly the most important unknown for global investors. (Humanitarian concerns are obviously the overriding issue but those are well covered elsewhere at The Globe and Mail). Energy, metals, fertilizer and every other material exported by Russia or Ukraine will be extremely expensive as long as the invasion continues.

Eventually, high prices will become deflationary – the more consumers spend on gasoline, for instance, the less disposable income they will have to spend at the mall or online. Food inflation caused by soaring fertilizer and wheat prices will have similar effects. This is the essence of a stagflationary environment.

The divergent paths of Canadian and developing world stocks may have begun with a Chinese tech wreck, but it is now being sustained by an unusual market dynamic of rising commodity prices at a time of war and, simultaneously, weak Chinese growth. I expect this correlation to stay broken for the foreseeable future. Soaring commodity costs will make economic growth and stock market rallies difficult for non-oil producing countries, while Canadian stocks will benefit.

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