Investors think that a mutual fund manager with experience should always know what is going to happen in the market — but this is simply not true. Since people are not perfect — I certainly have yet to meet the perfect human being — and markets are comprised of human beings, then markets are not perfect. Dare I bring up the example of the erroneous multi-year pricing of the oxymoronic AAA-rated subprime CDOs?
With that said, I have a real conundrum at present. I happen to think that the credit markets are smarter than the equity markets. Even though the credit markets are also comprised of imperfect human beings, those that trade bonds in size happen to be professionals (more so than those that trade stocks). And right now they are sending an enormously conflicting signal — junk bonds are at new 52-week highs while two-year note yields are a hair above all-time lows. This makes no sense.
This is relevant for investors in emerging markets because the U.S. is a near-$16 trillion economy and — combined with the E.U. $15 trillion economy — is pretty much two-thirds of the global economy. It is one thing for Europe to have problems; it is quite another for the U.S. and Europe to have problems. The iShares iBoxx High-Yield Corporate Bond ETF (NYSE: HYG) is supposed to be highly sensitive to economic performance in the U.S. — the better the economy, the higher the price.
In addition, the U.S. two-year Treasury note yield is supposed to be highly sensitive to economic performance in the U.S. — the worse the economy, the higher the price or lower the yield; this is why two-year T-note yields were positively-correlated with junk bond prices for most of the last three years, but not in the past two months. They are both showing exactly the opposite at present. Take a look at this chart:
In such puzzling situations, I consult other markets to see if there is more insight to be gained. Copper was weak since mid-April as the Chinese central bank pressed with monetary tightening measures. But copper has perked up notably last week — this is a positive. Still, copper is more of a play on emerging markets economic growth (which is more natural resource intensive), than it is on the health of the U.S. or E.U. economies.
It would be terrific if two-year note yields are sending a false signal, but we can’t know this for sure. Recently, junk bond prices have been rallying. Treasury bonds have been rallying too, while China H-shares, Russia and India have all advanced around +13%. The small-cap Brazilian sector as represented by the Market Vectors Brazil Small-Cap ETF (NYSE: BRF) has doubled that performance, soaring almost +30% since the end of June.
BRF is a play on the real Brazil considering that the Brazil iShare (NYSE: EWZ) is 40% weighted in two stocks — mining giant Vale (NYSE: VALE) and oil giant Petrobras (NYSE: PBR). This is not a bad thing per se, but given the complicated $225 billion in financing that PBR has to pull off in the next couple of years to develop deep-sea oil off the coast of Brazil — I wonder how the Gulf disaster is affecting PBR’s strategy — it makes the EWZ ETF a little complicated to handle.
Luckily, the ETF industry — which on more than one occasion has done a disservice to its clients — has now come up with two new Brazilian ETFs — the Global X Brazil Midcap ETF (NYSE: BRAZ) and the Global X Brazil Consumer ETF (NYSE: BRAQ). I have looked through the holdings of both funds and they both make sense. However, I think that BRAQ is a little better as it is more targeted towards the Brazilian domestic demand story.
While looking at the Brazilian ETFs, I also noted that the same issuer introduced one ETF geared towards copper (NYSE: COPX) and one towards silver miners (NYSE: SIL). Those are interesting too, but the trading volumes are yet illiquid so one has to be careful with execution; limit orders are more appropriate. In addition, the time to act isn’t now — I wouldn’t buy either the silver or the copper ETF here. Overall, the weaker economic data in the West — confirmed by the action in two-year notes — has me worried somewhat.
What I would do right now is short some silver for a short-term that I have previously discussed. The suggested positions have not yet moved much, but I still think they will for the reasons described earlier.
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