A Distinctly Canadian View Of Emerging Markets
Figuring out whether developed equity markets will outperform emerging market stocks has been no easy task, even if the choices couldn’t be any starker. By now, we are all familiar with the potential benefits of emerging markets: They have grown at a faster pace than developed economies, their population is younger , and they will soon be expected to aspire to consume many of the things people in the developed world take for granted. Sounds pretty good, right? Not so fast. These seeming positives have been in place for many years, and yet emerging markets have pretty consistently underperformed most developed markets since 2011. A combination of falling commodity prices, heightened political risk, slower (but still relatively brisk) economic growth, rampant corruption, a stalled reform agenda and limited earnings growth have all weighed on performance to one degree or another across the emerging world over this time period. So while emerging markets appear inexpensive, they are not unambiguously cheap. For Canadian investors, it’s even less clear if emerging markets will prove to be a winning destination for investment capital. As I’ll show, the loonie has tended to move with EM currencies, correlations between EM and Canadian equities have been high, and the sector composition was reasonably similar for a long time. That said, some of these factors are changing and even boosting the allure of holding EM equities in a portfolio. Currency Since the January lows, emerging market stocks have posted sizeable returns in US dollars, but the results are much less impressive in Canadian dollar terms, thanks to strength in the loonie. Some of the same factors lifting emerging market stocks, bonds and currencies also support the Canadian dollar and Canadian stocks: a rebound in commodity prices, a more patient Federal Reserve and less dire news about the global economy, especially out of China. This result shouldn’t seem all that surprising; the Canadian dollar has closely tracked emerging market currencies since 2010 (see the chart below). Consequently, Canadian investors don’t get as much of a boost to performance from appreciating EM currencies when risk appetites are growing and the global economy is accelerating, because the Canadian dollar is typically rising too. That said, EM currencies could potentially appreciate against the loonie given how far they’ve fallen. Click to enlarge Correlation Assets that exhibit a high positive correlation have more muted diversification benefits. If emerging market currencies and the Canadian dollar tend to appreciate together, then what about the correlation between EM and Canadian stocks? Here again, there’s another tight fit and another reason for Canadians to be apprehensive about the diversification benefits of owning emerging market equities. Looking at the chart below, Canadian equities have been much more positively correlated to EM equities since 2005 than to US or other international developed stock markets (represented by MSCI EAFE). That said, we should note that the high positive correlation of EM and Canadian equities have declined in recent years, boosting the diversification benefit. Click to enlarge Composition One reason correlations were this high – and the diversification benefits for Canadian investors this low – may have something to do with the similarity of industry exposures: the energy, materials and financials sectors made up more than half of the market cap of both Canadian and emerging market stocks. In the past five years, however, something interesting has happened. Thanks to the initial public offerings of many high-tech companies, the information technology sector has grown to more than a fifth of the emerging market equity index (see the chart below), whereas it’s less than 3% of the MSCI Canada index. As a result, EM may begin to deviate more from Canadian equities because of shifting sector exposures. The expansion of the tech sector is both a sign of, and offers investors exposure to, the convergence of emerging markets to developed economies. Click to enlarge Although not without risks, we’re warming up to emerging market equities and continue to believe in the possibility of improved investment returns based on better demography, faster growth and pent-up consumer demand. For Canadian investors, we see room for EM currency appreciation versus the loonie and better portfolio diversification benefits over time than has historically been the case. Source: BlackRock Investment Institute and Bloomberg. This post originally appeared on the BlackRock Blog.