High Yield Thunderbirds are Go

The “yield/risk” seeking theme that has gripped world financial markets since mid March (perhaps since mid October) is alive and kicking. To get an indication of market sentiment we look at the relative behaviour of high risk and low risk securities of each asset class. Specifically this entails studying the relationships of the following:

• Equities – world small caps vs. large caps and emerging market small caps vs. developed market small caps,
• Fixed Income – junk grade vs. investment grade debt,
• Currencies – emerging market currencies relative to the USD and high yield vs. low yield,
• Commodities – industrial metals vs. the broad commodity market.

We won’t get too involved as to the relative merits of each of these relationships but suffice to say that years of experience and tell us that every significant movement in world financial markets has been preceded by “out of character” behaviour in a number of the relationships discussed above.

Everything is fine (i.e. there is no problem for a continuation of the “high yield” trade) except for the behaviour of emerging market small caps relative to developed market small caps. We have found that time and time again problems in world financial markets first show up in emerging markets because this is where liquidity is relatively poor. Usually it is emerging market currencies that first take the heat then emerging market small cap stocks. Anyway, whilst emerging market small caps are showing signs of breaking down against developed market small caps there has been no concerted breakdown as yet. We really have to wait and see if the relative underperformance of emerging market small caps feeds on through to emerging market currencies, junk grade bonds etc……..until then we remain alert but continue to remain positioned for a continuation of the risk/high yield trade.