Tuesday, 6 March 2012

Canadian Equities and Emerging Markets

It is hard to grow an economy without sufficient natural resources.Countries that have their own natural resources can exploit them, those that do not have sufficient natural resources need to buy them. Here in Canada, we are often told how important Canada's natural resources are to other economies.

As an example of how resource use patterns vary by country income class consider energy use. The chart below shows energy use (kt of oil equivalent) for high income countries (HIC), low & middle income countries (LMY) and upper middle income countries (UMC). Notice how energy use in developing countries has been growing steadily since the mid 2000s.

At the end of February the TSX composite index (represented by the ETF with ticker symbol (XIC)) broke  above its 10 month moving average indicating (hopefully) a new period of upward momentum.

The US equity markets have had a good run so far this year while the TSX has lagged behind. It is true that Canada does most of its trade with the US but from an investment in equities perspective, Canada's  fortunes are increasingly tied more to emerging economies. Here are some regression results from a model relating Canadian stock prices to the stock prices of EAFE, EM and USA. All of the stock price indexes are in US dollars. The regression is estimated in logs so that the estimated coefficients can be interpreted as elasticities.  The regression is consistent with a cointegrating relationship (residuals are stationary) and is best thought of as representing a long-run relationship between the variables. Notice that the coefficient on the emerging markets variable (EM) is positive and statistically significant. A 1% increase in EM increases the Canadian equity market by 0.81%. In this model, the other equity markets (EAFE and US) do not have a statistically significant impact on Canadian equities.