Canadian investors are whistling past the graveyard as they continue to largely ignore the financial crisis that is erupting in emerging markets. Given that the S&P/TSX composite index has moved virtually in lockstep with emerging markets over the past decade, their lack of alarm makes no sense.
At the risk of yelling fire in a crowded movie theatre, let me say that Canadian investors are vastly underestimating the risk to their portfolios.
The accompanying chart shows why I'm worried – the Canadian equity market is defying gravity relative to the MSCI Emerging Markets Index. The past decade has seen the TSX and MSCI benchmark move together with a remarkably high 0.94 correlation. Yet the lack of recent volatility in Canadian stocks suggest that investors remain confident the emerging markets slide won't hurt their domestic portfolios.
Since July of this year, the S&P/TSX composite has climbed higher while emerging markets equities have rolled over. A resumption of the trend that has existed for the previous 10 years means that either domestic stocks are poised to fall or emerging markets equities are poised to spring higher.
Unfortunately, the major developing countries show no signs of rallying any time soon.
The headline "Rupee in free fall, stagflation setting in, risks of sovereign downgrade and investor panic rising" (from the wonderfully useful Sober Look economics blog) provides a good sense of the severity of financial conditions in India. Brazil, another member of the BRIC club, has seen its currency drop 16 per cent since March and now Indonesia's rupiah and the Turkish lira are enduring daily beatings in the market.
All told, the emerging markets benchmark has fallen 15 per cent since the beginning of the year.
So is there any reason to think that the Canadian stock market has decoupled from the emerging markets exchanges that it has tracked so closely in recent years?
One reason for hope is that Chinese economic data – to the extent we trust the government's less-than-reliable numbers – still looks okay. Problem is, China makes up less than 20 per cent of the MSCI Emerging Markets index because of its relatively small equity market.
Another reason for optimism is the resurgent U.S. economy. But recent data from south of the border on new home sales has disappointed expectations. In addition, household consumption trends remain abysmal and add to my worries that U.S. consumers are not the force they once were.
So while it's conceivable that the close relationship between Canadian and emerging markets equities no longer applies, I think it's more probable that the relationship is going to reassert itself. The S&P/TSX composite is 39 per cent materials and resource stocks, both of which depend on emerging markets demand for profit growth.
The chart implies that Canadian investors have two choices – either reduce equity exposure or pray fervently for a sharp rebound in emerging market economies.
Am I guaranteeing a domestic market collapse? No. The only people who say they're sure about where the market is headed next are people who are trying to sell you something. But I am willing to say that the risks to holding Canadian stocks are high and rising.
It's important to understand that a potential downdraft in equity markets does not necessarily translate to a decline in the Canadian economy. The stock market is very much sensitive to conditions in emerging markets because of the TSX's hefty exposure to energy and mining stocks. But even if they slump, economic growth can still be driven by sectors such as auto making that are not represented in the index and are largely immune from emerging-market economies.
For investors, though, the market trends of the past decade point to rising danger around Canadian equities.
Raise some cash. The worse that happens if I'm wrong is that you'll trail the benchmark for a bit. If it goes the other way, and the TSX falls, you'll kick yourself for ignoring the warnings provided by financial stress in emerging markets.
Scott Barlow