Lagging S&P 500 is good news for Canadians

Scott Marlow | May 28, 2019 | The Globe and Mail

Economic growth differential between U.S. and rest of world could lead to better returns

Morgan Stanley strategist Andrew Sheets’s highest conviction trade idea is that the S&P 500 will underperform the rest of the global equity market. For Canadian investors, this is even better news than it appears on the surface.

Mr. Sheets’s relative pessimism on U.S. equities is based on the economic growth differential between the United States and the rest of the world. The S&P 500 historically outperforms when U.S. gross domestic product growth is close to the global average. Morgan Stanley believes that the U.S. economy is set to slow, and accelerating economies elsewhere will lead to better returns outside the world’s largest stock market.

The accompanying charts focus on emerging markets because they are most relevant to S&P/TSX Composite returns. In the first chart, the bars represent excess GDP growth of emerging markets over U.S. growth.

The final blue bar, for example, shows a reading of 2 per cent at the end of the first quarter of 2019. This is simply emerging market economic growth for the first quarter of 2019 (5.2 per cent), minus U.S. growth of 3.2 per cent – emerging-world economies grew two percentage points faster than that of the United States.

The purple line on the chart depicts the relative returns of the S&P 500 and the MSCI Emerging Markets Index. The value of the MSCI index is divided by the S&P 500 so a rising line indicates emerging markets outperforming U.S. equities.

The end of the first quarter of 2010 is a key point on the chart. The blue bar at that juncture indicates emerging-market growth peaked at 7.8 per cent above U.S. GDP. Two quarters later, at the end of September, emerging market equity returns (the purple line) began a decline relative to the S&P 500 that continues today.

The overall pattern on the chart is that the performance of emerging market stocks relative to U.S. equities follows the path of comparative GDP growth, often with a one- or two-quarter lag. Mr. Sheets says the trend is about to change, leading to stronger returns from emerging market equities. The grey bars represent the results of consensus economist estimates for developing world and U.S. economic growth.

By mid-2020, emerging market economic growth is set to improve to 3.2 per cent above the United States. If historical patterns persist, the MSCI Emerging Markets Index should shortly begin to outperform the S&P 500.

These projections are extremely important to Canadian investors because the S&P/TSX Composite and MSCI Emerging Market Index have shown a high degree of correlation, as the second chart underscores.

The chart shows the returns for a hypothetical $1,000 (Canadian) invested in the S&P/TSX and the emerging markets index in June of 1999. Remarkably, the benchmarks have moved so similarly that the value of the investments after almost 20 years differ by only $37.49.

Changes in the value of the U.S. dollar play a big role in the similar performance of domestic and developing world stocks, but the point remains that returns are extremely similar.

The current estimates for economic growth in the developing world and the United States point to outperformance by emerging-market equities and Canadian equities when compared with the S&P 500.

For the original article, please go to: https://www.theglobeandmail.com/investing/markets/inside-the-market/article-why-a-lagging-sp-500-is-good-news-for-canadian-investors/