Is Canada an Emerging Market?

Well, no. But there is more in common besides a declining currency.

Since the 1980s the phrase emerging markets has been used to distinguish between developed and developing countries. Emerging markets have been identified as a separate asset class for investors characterised by higher returns but also higher risk.

Over the period 2000-2010 the annualized return from emerging markets was 10.9% versus 1.3% for developed markets. In particular, emerging markets largely escaped the financial meltdown of 2008. More recently the news has been less impressive:

Over the past three years, an index of Western firms with high emerging market exposure has lagged the S&P 500 by 40%. Walmart, for example, is reducing the number of stores in emerging markets¹.
In mid-2013 emerging market equities and currencies fell as the U.S. signalled the end of low interest rates and made lending abroad in search of higher yield a less attractive proposition. Headlines such as “Emerging Markets Are Crashing” and “Broken BRICS” appeared.

Fortunately, a recent Credit Suisse report² provides a longer term analysis. We borrow extensively from the report in what follows.

A useful asset class for investing purposes must have a positive expected return and contribute to portfolio diversification by behaving differently than other asset classes. In every decade since 1950, emerging markets have delivered positive returns, beating developed market returns three out the seven periods. When comparing a price index of developed countries as a group with a price index of a group of emerging market countries then the indices behave differently ( i.e. the correlation is less than 1.0). This difference has been shrinking since the 1980s because of globalisation: big European firms, for example, have tripled their sales to emerging markets since 1997 and American sales have doubled. Finally, emerging market countries have more in common with other emerging market countries than they do with developed countries. The converse is also true: developed countries have higher correlations with other developed countries than with emerging market countries. One exception is Canada. Because of Canada’s resource orientation, its market is more in sync with emerging markets than developed countries. This means that emerging markets offers less diversification to Canadian investors than to American investors. Conversely, Canadian investors enjoy better diversification from investing in other developed countries than their American or European counterparts. In that regard a Canadian investor gets about the same diversification benefit from investing in developed countries as a Chinese or Mexican investor.

Does this mean that Canada should be regarded as an emerging market? Not yet. The delineation between developing and emerging countries is typically based on GDP per capita with the cut off of USD $25,000. Canada’s GDP per capita is a comfortable USD $52,218 (2012). Interestingly, Portugal has a GDP per capita of USD 20,663.

Chasing Growth Countries

One investor affliction that impacts decisions about which countries to invest in, especially emerging markets, is the persistent (but incorrect) belief that investing in countries with high economic growth leads to the highest returns. In fact countries with the lowest past GDP growth tend to have annualized return double those with the highest past growth. Many emerging markets have had strong GDP growth, misleading investors to expect high market returns. This can easily lead to disappointment and capital flights. A longer term view offered by the authors is that even though emerging markets have grown from 18% of world GDP to 33% over thirty years, they should continue to be seen as riskier, and, as such, should offer outperformance in excess of returns from developed counties of around 1.5% per year as compensation.

At PWL we pay close attention to the additional returns and risk mitigation from international diversification. Our models currently indicate that emerging market equities offer additional returns over Canada of 1.5%, 3.2% over the U.S., 1.1% over Europe and 2.2% over the Pacific region.

Emerging markets are a growing part of the global economy but still retain distinct characteristics that make them a useful contributor to robust portfolios. Canadian investors get to enjoy one of the highest standards of living in the world coupled with the diversification benefits reserved for emerging market investors. That is a good deal.

¹ The Economist, March 8th-14th, 2014

² Emerging Markets Revisited, Elroy Dimson, Paul Marsh and Mike Staunton, London Business School, published in Credit Suisse Global Investment Returns Yearbook 2014. See also Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns, Princeton University Press, 2002