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A currency crisis in India is only the latest sign that the emerging markets investment story is showing serious signs of fatigue.
Since the Canadian stock market depends heavily on demand for raw materials from the developing world, many Canadians should consider moving more of their investment assets into the United States as a way to shield themselves from this slowdown in emerging economies.
The shift in growth leadership toward the U.S. and away from China and the emerging markets is already under way. Strategies that worked for Canadian investors over the past decade, such as focusing on resources and a predominantly loonie-based portfolio, are likely to hinder performance in the decade to come.
The economies of the BRIC nations are embroiled in turmoil as global investment flees. The central banks of both Brazil and India have enacted desperate measures in the past few weeks – capital controls and restrictions on gold imports in India's case – to protect their plunging currencies.
China's economy, to the extent we can trust the data, looks okay for now. But economists both inside and outside the country's borders have reached the view that China's reliance on investment and construction – the source of much global resource demand in recent years – must eventually end in favour of more household consumption.
Most Canadian portfolios are vastly unprepared for the change in global market emphasis.
Many Canadian investors feel that by mirroring the sector weightings of the S&P/TSX composite, through index investing or other means, their portfolio is well diversified and can easily weather a BRIC slowdown. Nothing could be further from the truth.
The benchmark's almost 40-per-cent weighting in materials and energy stocks means that to global eyes, the S&P/TSX composite is just another emerging market index. Using monthly data from 2003, the correlation between the MSCI Emerging Markets Index and the TSX (monthly data) is 0.944 – they are more or less the same lines.
The picture is the same for the loonie. The domestic currency (in U.S. dollar terms) has closely tracked the commodity prices and resource stocks that benefited from emerging markets expansion. As we've discussed in ROB Insight at length, there is currently a divergence between the loonie's value and the S&P/TSX Materials index. This will correct through a sharply lower loonie, or sharply higher commodity stocks. In light of slowing emerging markets economies, the former is more likely.
The change in performance leadership to the developed world from emerging markets assets is not a prediction – the process is already under way. The past 12 months have seen the S&P 500 outperform the S&P/TSX by 15 per cent and the MSCI Emerging Markets Index by 22.7 per cent. Canadian investors who have not diversified into U.S. markets are being left behind.
There's no need for panic, but investor complacency is equally misplaced. It's true that U.S. markets have been volatile as they adjust to the new higher rate environment, but Canadians should not be dissuaded from adding U.S. stocks. Recent volatility could provide the bargain prices that will allow investors to extract the maximum benefit from the shift back to developed market assets.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.