Merrill Lynch strategists are extremely bullish on emerging market stocks but this optimism is based on a U.S. perspective. For Canadian investors, shifting investment assets from domestic to developing world stocks is a more complicated, and possibly unnecessary, decision.
Ajay Kapur is Merrill Lynch's strategist for Asia and global emerging markets. Mr. Kapur is now bullish on developing world stocks for both the short and longer term, citing "attractive relative valuations, more competitive EM currencies, improving economic growth and earnings trends, and an expected torrent of free cash flow." In the latter case, the strategist believes corporate free cash flow in emerging markets will more than double before 2018 as investment in excess capacity slows.
U.S. investors appear to share this optimism. Last week, the iShares MSCI All Country Asia ex Japan ETF saw its largest inflow of new investment in 12 months, according to Bloomberg data.
The first chart below suggests that for U.S. investors, a wholesale reallocation of investment dollars into emerging markets will require a sizable leap of faith. The chart shows the value of a $10,000 (Canadian dollars) investment in each of the S&P/TSX composite, S&P 500 and MSCI emerging markets index. The U.S. equity index has been the clear winner.
Note that the value of the S&P/TSX and emerging markets equity positions have tracked each other closely over the past five years. The second chart, showing just the value of Canadian and developing world equity investments, makes this even more clear.
The similarities between Canadian and emerging-market equity performance arise from two main factors. One is currency – both markets benefit roughly equally when the U.S. dollar falls and depreciate when the greenback is strong, as it has been for much of the past half-decade.
The other reason for the correlation is commodity prices. Emerging-markets economic growth is resource-heavy, requiring more basic resources per unit of growth than G7 nations. Strong growth in emerging economies lifts commodity prices, and therefore profits for the more than 30 per cent of the S&P/TSX composite that is made up of resource stocks.
Mark Mobius of Franklin Templeton Investments, the unquestioned dean of emerging markets investors, noted in a recent interview with The Globe that technology stocks were increasingly dominating developing world equity indexes. If that's the case, it has not shown up in the relative performance of the S&P/TSX composite and the MSCI emerging markets index. Technology makes up only 3 per cent of the domestic benchmark, and we'd expect the correlation to break down if developing world stocks were driven by technology stocks.
Emerging market stocks might be attractive for American investors looking for stronger growth prospects in light of Merrill Lynch's optimism. But for Canadians, recent market history indicates the developing world offers little in the way of portfolio diversification. That may change in the years ahead, of course, but for domestic investors the easiest decision is to stand pat with familiar Canadian companies.