The Australian stocks most at risk from a rise in global bond yields

From Business Insider.

Global bond yields are poised to rise again and that will leave key sectors of the Australian share market exposed, according to Credit Suisse.

In a research note called “The Bondcano is back”, equity analysts Hasan Tevfik and Peter Liu have looked into which Aussie stocks are most vulnerable to the effects of higher bond yields.

Here’s the list:

It’s mostly comprised of stocks in stable industries which provide a consistent stream of dividend income to investors. In other words, stocks that act as a proxy for bonds.

It follows that such stocks are more attractive in the current environment, as they provide a safe return on investment that’s still higher than the return provided by low-yielding bonds.

Tevfik and Liu’s list also includes stocks that are currently trading on high price-to-earnings ratios, and stocks with high leverage which have benefited from cheap debt in the low bond yield environment.

Global bond yields have fallen this year as bond markets began to doubt the pace of inflation growth in developed markets.

However, Credit Suisse expects the yield on the benchmark US 10-year treasuries to push higher in the second half of the year.

“Our rate strategists expect US Treasury yields to reach 2.8% by the end of the year driven by a combination of stronger inflation, better economic activity vs expectations and further signs that central banks will continue their process of normalisation,” Tevfik and Liu said.

The two analysts said that the Aussie stock sectors most at risk from a rise in bond yields currently make up 22% of the market capitalisation of the ASX200.

They say the valuation of those sectors is currently trading on a price-to-earnings ratio of 21 times projected earnings over the next 12 months, which is 25% higher than the market average:

Tevfik and Liu also considered the influence of passive investment funds in their analysis.

Stocks which are most vulnerable to a rise in bond yields also make up a large position in the holdings of passive funds, due to their safer and less volatile nature.

Given the huge rise of passive investment vehicles in recent years, the analysts said there would be no major falls in their list of at-risk stocks unless passive funds changed their holdings.

Looking at the market more broadly, Tevfik and Liu said that share prices generally benefit when interest rates are low, and equity investors should be wary of the “Bondcano”.

“We think the Bondcano will continue to erupt, so what has been a tailwind for large parts of the equity market will become a headwind,” they said.

However, the threat to some companies from rising bond yields will be an opportunity for others. The two analysts added a table of stocks which stand to benefit if bond yields rise:

Tightening Is Toxic

From Moody’s.

The FOMC is expected to announce a 25 bp hike in the federal funds rate’s midpoint to 1.125% on Wednesday, June 14. Despite March 14’s 25 bp hiking of fed funds to a 0.875% midpoint, the 10-year Treasury yield fell from March 13’s 2.62% to a recent 2.20%. If the 10-year Treasury yield does not climb higher following June 14’s likely rate hike, the scope for future rate hikes should narrow.

At each of its end-of-quarter meetings, the FOMC updates its median projections for economic activity, inflation, and the federal funds rate. At the March 2017 meeting, the FOMC’s median projections for the year-end federal funds rate were 1.375% for 2017, 2.125% for 2018, and 3.0% for 2019 and beyond. However, the recent 10-year Treasury yield of 2.20% implicitly reflects doubts concerning whether the fed funds rate’s long-run equilibrium will be as high as 3.0%.

Perhaps, the FOMC will supply a lower long-run projection for fed funds. Nevertheless, in order to ward off speculative excess in the equity and corporate credit markets, the FOMC may wisely decide to overestimate the likely path of fed funds. The last thing the FOMC wants to do is help further inflate an already overvalued equity market.

Moreover, equity market overvaluation has pumped up systemic liquidity by enough to narrow high-yield bond spreads to widths that now under-compensate creditors for default risk. According to a multi-variable regression model that explains the high-yield bond spread in terms of (1) the VIX index, (2) the average EDF (expected default frequency) metric of non-investment grade companies, (3) the Chicago Fed’s national activity index, and (4) the three-month trend of nonfarm payrolls, the high-yield spread’s recent projected midpoint of 410 bp exceeds the actual spread of 380 bp. Moreover, after excluding the VIX index from the model, the predicted midpoint widens to 500 bp. The 90 bp jump by the predicted spread after excluding the VIX index is the biggest such difference for a sample that commences in 1996. The considerable downward bias imparted to the predicted high-yield spread by the recent ultra-low VIX of 10.2 points highlights the degree to which a richly priced and highly confident equity market has narrowed the high-yield bond spread. (Figure 1.)

High-yield spreads can narrow amid Fed rate hikes

There is absolutely nothing unusual about financial market conditions easing amid Fed rate hikes. When the fed funds’ midpoint was hiked from 0.125% to 0.375% in December 2015, the high-yield bond spread quickly swelled from a November 2015 average of 697 bp to February 2016’s 839 bp. However, though the midpoint is likely to reach 1.125% at the FOMC’s upcoming meeting of June 14, the high-yield spread has since narrowed to a recent 380 bp. (Figure 2.)

Early on, Fed rate hikes often were followed by thinner corporate bond yield spreads. For example at the start of the first tightening cycle of 1991-2000’s economic upturn, fed funds was hiked from year-end 1993’s 3.0% to 5.5% by year-end 1994. Despite that 2.5 percentage point hiking of fed funds, the high-yield bond spread managed to narrow from Q4-1993’s 439 bp to Q4-1994’s 350 bp. Not until the 10-year Treasury yield dipped under August 1998’s 5.5% fed funds rate did the high-yield spread widen beyond 600 bp.

It’s also worth recalling how the market value of US common stock soared higher by 19.4% annualized, on average, from January 1994 through March 2000 despite a hiking of fed funds from 3.00% to 5.75%. However, once fed funds reached 6.00% in March 2000, a grossly overvalued equity market finally crested and began a descent that would slash the market value of US common stock by a cumulative -43% from March 2000’s top to October 2002’s bottom. (Figure 3.)

The series of Fed rate hikes that occurred during 2002-2007’s recovery told a similar story. Notwithstanding a steep and rapid ascent by fed funds from the 1% of June 2004 to 5.25% by June 2006, the high-yield bond spread averaged an extraordinarily thin 340 bp from July 2004 through July 2007. At the same time, the VIX index averaged a very low 13.2 points despite the span’s 425 bp hiking of fed funds. Moreover, from June 2004 through October 2007, the market value of US common stock advanced by nearly 11% annualized, on average.

 

Speed Limits for Financial Markets? Not So Fast

From The IMFBlog.

On the afternoon of May 6, 2010, a financial tsunami hit Wall Street. Stunned traders watched as graphs on their computer screens traced the vertiginous 998-point plunge in the Dow Jones Industrial Average, which erased $1 trillion in market value in 36 minutes.

There was little in the way of fundamental news to drive such a dramatic decline, and stocks bounced back later that day. The event, quickly dubbed the “flash crash,” focused attention on the role of high-frequency trading and algorithms in amplifying market volatility.

Thick vs. thin

So far, though, there’s been remarkably little in the way of hard evidence on whether advances in information and communication technology help magnify market turbulence. Now, economists Barry Eichengreen, Arnaud Mehl, and the IMF’s Romain Lafarguette are trying to fill that gap. Their findings, surprisingly, are that faster transmission of market-moving news reduces volatility rather than increasing it.

The three economists present their research in a new IMF working paper titled “Thick vs. Thin-Skinned: Technology, News and Financial Market Reaction.

The title refers to two popular hypotheses. The “thin-skinned” hypothesis holds that advances in information technology cause prices to react more violently to news by enabling strategies associated with volatility, such as algorithmic trading and stop-loss orders. High-frequency traders popularized by Michael Lewis’s 2014 book, Flash Boys, also have been blamed.

The “thick-skinned’’ hypothesis holds the opposite: advances in technology suppress volatility, because information that spreads more quickly reduces the information disadvantages of uninformed investors. Such investors “follow and amplify market trends by relying excessively on past or present returns to anticipate future returns,” the authors write. In other words, they engage in herd behavior, selling when prices fall and buying when prices rise. Better informed investors are less likely to follow the herd.

Ingenious test

Eichengreen and his co-authors have come up with an ingenious way of testing these hypotheses, by measuring reactions to news transmitted across superfast submarine fiber-optic cables.

“This result is consistent with the view that technology levels the informational playing field by easing access to information and that it thereby reduces trend following behavior,” they write.

Their laboratory is the world’s biggest financial market, the one for currencies, where average daily volumes exceed $4 trillion (more than the combined GDP of Italy and Brazil). They measured the reactions of currencies to major US economic news such as changes in gross domestic product, consumer prices and monetary policy.

London calling

To see how the speed of transmission affects the magnitude of the market reaction, they divided the markets into two groups: One receives news faster because it has direct fiber-optic connections with the major financial centers—Tokyo, London, and New York. The second set receives news more slowly, because it lacks direct fiber optic connections.

The amount of data they amassed is impressive: 240,430 observations for 56 bilateral exchange rates against the dollar between January 1, 1997, and November 30, 2015. Their conclusion: currencies traded in places which get their news faster via direct fiber-optic connections react less than currencies in places that receive their news more slowly. In fact, the reaction in markets with direct connections is 50 percent to 80 percent smaller.

Authors Eichengreen, Lafarguette, and Mehl decline to pass judgment on proposals to damp asset-price volatility by slowing the velocity of data flows with measures such as electronic “speed bumps.” But their study does suggest that transmitting information more broadly may reduce volatility.

 

 

That Other Bubble

From Bloomberg Technology

The financial world has been obsessed lately with debating whether we’re in a different sort of tech bubble, this time among public companies. One stock market strategist recently warned of “tech mania.”

The talk about tech stock froth is based on three interrelated facts: The performance of the U.S. stock market is more dependent on technology companies than any time in more than 15 years. Investors are willing to pay more to own these shares. And they’re crowded mostly into the same handful of big tech companies such as Amazon and Google parent company Alphabet.

Putting those data points together, some market watchers are worried that what has gone up in tech must inevitably come down — and take the whole ebullient stock market down with it.

It’s easy to understand why the finance world can’t stop talking about technology stocks. In the S&P 500 index, the sector accounts for about one quarter of the total market value of the equity benchmark. That is the largest share since 2001, according to Bloomberg data. (It’s worth noting that the S&P 500 doesn’t classify Amazon as a tech company, which is nuts. If the e-commerce giant took its rightful place, even more of the index would be tied to technology.)

Plus, money is pouring into the sector at a rate not seen in 15 years, according to research from Bank of America Merrill Lynch. And while investors aren’t paying stratospheric prices, as they did in the late 90s dot-com bubble, values of a broad collection of tech companies relative to their profits are higher than they have been since early 2004, Pavilion Global Markets calculated last week.

When you start mentioning things that haven’t happened to tech stocks since the early 2000s, you know we are living in odd times.

Every time there is tech froth, people will argue why this is or isn’t different than 1999. This isn’t 1999. But that doesn’t necessarily mean the exploding value of companies such as Apple, Netflix, Nvidia and Amazon is sustainable. I won’t try to predict the future, but the debate surely shows the outsized power of tech firms to drive global growth and equity markets.

Bubble talk isn’t likely to go away. Apple in May became the first U.S. company to top $800 billion in the total value of its stock. Now there’s a race to become the first company to sustain $1 trillion or more in market capitalization. Will it be Apple, or maybe Alphabet or Amazon? No non-technology companies, apart from Saudi Arabia’s mega government oil company, have a shot at the moment.

Stock-picker Altair’s shock sell-off could trigger the crash

From The NewDaily.

A veteran stock-picker’s shock decision to sell out of the share market entirely and return millions in cash to investors could trigger the very “calamity” he fears, according to experts.

Philip Parker, head of Altair Asset Management, announced in an open letter on Monday that he has given up on picking the market for the next six to 12 months because share and property prices will soon collapse.

It has triggered widespread speculation in the industry. Is it a publicity stunt or a prescient warning?

Many have pointed to the latest CoreLogic figures for May, which showed a drop in Melbourne and Sydney dwelling prices, to say the fund manager is onto something.

Preliminary figures from the property researcher showed dwelling values in Sydney fell 1.3 per cent and 1.8 per cent in Melbourne in the first 29 days of May.

Prices in Perth fell 0.6 per cent, while Brisbane was up 0.8 per cent and Adelaide prices increased by 0.5 per cent.

CoreLogic acknowledged that prices normally fall or moderate in April and May, but it attributed this result to banking regulator APRA’s crackdown on investor lending.

Last month, Sydney’s red-hot market showed early signs of cooling, with dwelling values inching down 0.04 per cent, while Melbourne values rose but at a slower pace than one month earlier.

Mr Parker, who markets Altair as a “high conviction” fund, wrote that he could not in good conscience keep charging fees “when there are so many early warning lead indicators of clear and present danger”.

“To me there are specific identifiers that are extremely recognisable that remind me of the late eighties and early nineties housing calamity,” he said.

“Giving up management and performance fees and handing back cash from investments managed by us is a seminal decision however preserving client’s assets is what all fund managers should always put before their own interests.”

Martin North, a property market analyst, said the only upside for the Australian economy at the moment is “sentiment and enthusiasm”, and that a shock move like Altair’s could be all it takes to tip the scales.

“Sentiment is crucial, which is why everyone wants to be buoyant and talk positive. There’s no doubt that with the international connectivity of the international markets, sentiment can be amplified and become self-fulfilling,” Mr North told The New Daily.

“If you call it right at the right point, you can make a lot of money. But what’s the collateral damage?”

Despite these concerns, Mr North gave credence to the potential triggers identified by Altair, namely: a property bubble burst in Melbourne and Sydney; a stock market bubble burst Australia-wide; a debt bubble burst in China; and political uncertainty in the US.

However, another property market expert, Dr Nigel Stapledon at the University of New South Wales, said Altair is “entitled to their view, but I don’t share it”.

He agreed that property prices are too high, but he said even if prices in Melbourne and Sydney fall by 10 per cent, Australians will barely notice so long as they are not forced to sell their homes.

If population growth persists, prices will recover, Dr Stapledon told The New Daily.

“Almost every year you have someone predicting Armageddon in the property market. Clearly prices are overpriced. You could easily have a 10 per cent price fall, but I don’t call that Armageddon.”

If the Chinese economy collapses, the Australian economy could enter a recession, and then immigrants might stop flocking here. Then we’d be in real trouble, he said.

“Those are risks. But there are always risks. It’s not clear to me those risks are going to emerge.”

Financials Are Under Pressure

The latest data on the S&P/ASX 200 Financials shows the 25 plus stocks in the index have collectively moved lower – and at a faster pace than the market. Though a little bounce today.

A range of factors are in play, including the bank tax, rising concerns about the banks exposure to property, and the risks of higher defaults in a low growth higher risk environment.

The bank credit default swap rate is higher, indicating higher funding costs and risks, and the yield curve is not helping.

Underlying this are the recent result rounds which showed that whilst volume may be up, net interest rates are not, and the pressure to slow loan growth, and lift margins will impact the competitive landscape and future volume growth.

Sell in May, and go away, possibly is good advice!

Macquarie Bank to address inadequacies within their wholesale FX businesses

ASIC has today accepted an enforceable undertaking (EU) from Macquarie Bank Limited in relation to the bank’s wholesale foreign exchange (FX) businesses, following an ASIC investigation.

ASIC is concerned that the bank failed to ensure that its systems and controls were adequate to address risks relating to instances of inappropriate conduct identified by ASIC.

ASIC Commissioner Cathie Armour said, ‘The wholesale spot foreign exchange market is one the world’s largest financial markets and the proper functioning of this market is of vital importance to the Australian economy.’

‘ASIC has now accepted undertakings from some of Australia’s largest market participants to put in place forward looking processes and controls to ensure that their foreign exchange businesses provide financial services honestly, efficiently and fairly.’

‘ASIC will continue to ensure that there can be ongoing confidence in how our financial institutions conduct themselves now and into the future,’ Ms Armour said.

ASIC identified the following conduct by employees of Macquarie in its spot FX business between 1 January 2008 and 30 June 2013:

  • On a number of occasions, Macquarie employees disclosed to external third parties confidential details of pending client orders including identification of a client;
  • On a number of occasions, Macquarie employees inappropriately disclosed to external third parties confidential and potentially material information about Macquarie’s trading activity associated with large pending AUD orders; and
  • On a number of occasions, when the market approached the trigger price of a stop loss order, Macquarie spot FX traders responsible for managing the order traded in a manner that may have been intended to cause the trigger price to trade when it might not have traded at that time.

ASIC is concerned that Macquarie did not ensure that its systems, controls and framework for supervision and monitoring were adequate to prevent, detect and respond to such conduct, which had the potential to undermine confidence in the proper functioning and integrity of the market.

Macquarie will develop a program of changes to its existing systems, controls, training, guidance and framework for monitoring and supervision of employees in its spot FX and non-deliverable forwards businesses to prevent, detect and respond to:

  1. inappropriate disclosure of confidential information to external market participants; and
  2. inappropriate order management and trading in respect of stop loss orders.

ASIC will appoint an independent consultant to assess the program and its implementation. The program will incorporate changes already made by Macquarie as part of ongoing reviews of its businesses.

Upon implementation of that program, for a period of three years, Macquarie will conduct an annual internal review of the program, which will be independently assessed, and provide an annual attestation from its senior executives to ASIC.

Macquarie will also make a community benefit payment of $2 million to The Smith Family to support The Smith Family’s financial services program aimed at improving young people’s understanding of money management.

ASIC encourages market participants to adhere to high standards of market practice, including those set out in the Global Code of Conduct for the Foreign Exchange Market, published by the Bank of International Settlements (BIS Global FX Code). The BIS Global FX Code provides a global set of practice guidelines to promote the integrity and effective functioning of the wholesale FX market. Phase 1 of the Code was published in May 2016, and Phase 2 is due for publication in May 2017.

ASIC is grateful for the assistance of international regulatory counterparts in progressing the investigation.

Background

Prior to accepting these EU from Macquarie, ASIC’s FX investigation has seen ASIC accept enforceable undertakings from each of the Westpac Banking Corporation, Australia and New Zealand Banking Group Limited, National Australia Bank Limited and the Commonwealth Bank of Australia (refer: 17-065MR and 16-455MR). The institutions also made voluntary contributions totalling $11 million to fund independent financial literacy projects in Australia.

The wholesale spot FX market is an important financial market for Australia. It facilitates the exchange of one currency for another and thus allows market participants to buy and sell foreign currencies. As part of its spot FX business, Macquarie entered into different types of spot FX agreements with its clients, including Australian clients.

Spot FX refers to FX contracts involving the exchange of two currencies at a price (exchange rate) agreed on a date (the trade date), and which are usually settled two business days from the trade date.

Non-deliverable forwards refer to FX forward contracts which, at maturity, are settled by calculating the difference between the agreed forward rate and a settlement rate (which is usually determined by reference to a benchmark published exchange rate). A FX forward contract is an agreement between two counterparties to exchange currencies at a future date at a rate agreed upon in advance.

The High Frequency Trading Arms Race Just Went Up A Notch

High Frequency Trading is an arms race in the quest for speed. It creates an ever more uneven playing field.  This article from Zero Hedge demonstrates to what lengths the high frequency traders will go for just a few millisecond advantage – which makes in the HFT world makes all the different between billions in profits and losses – Bloomberg reports that a mysterious antenna has emerged in an empty field in Aurora, near Chicago, and a trading fortune depends on it.

Strange? Of course: as BBG’s Brian Louis admits “it was an odd transaction from the outset: $14 million, double the going rate, for a 31-acre plot of flat, undeveloped land just west of Chicago. In the nine months since, the curious use of the space has only added to the intrigue. A single, nondescript pole with two antennas was erected by a row of shrubs. Some supporting equipment was rolled in. That’s it.”

As it turns out, those antennas – as readers may imagine – were anything but ordinary. Same goes for the buyer of the property: anything but your typical land investor, although the name will be all too familiar to those who have followed our reporting on HFT over the years: it was Jump Trading LLC, “a legendary and secretive trading firm that’s a major player in some of the most important financial markets.”


Equipment on land purchased by an affiliate of Jump Trading

Jump Trading affiliate World Class Wireless purchased the 31-acre lot for $14 million, according to county records. “They paid probably twice as much as it’s worth,” said David Friedlandof Cushman & Wakefield. “I don’t see anyone else paying close to that price.”

There was a reason why Jump overpaid so much: it was an investment into guaranteed future returns.

Because ultimately the purchase was all about the location: just across the street lies the data center for CME Group, the world’s biggest futures exchange. By placing its antennas so close to CME’s servers, Jump hopes to shave maybe a microsecond off its reaction time, enough to separate a winning from a losing bid in trading that takes place at almost the speed of light. Enough to make billions in profits if done successfully millions of times every minute for year.

As Bloomberg describes the land grab, “it was the latest, and perhaps boldest, salvo in an escalating war that’s being waged to stay competitive in the high-speed trading business.”

 The war is one of proximity — to see who can get data in and out of CME the quickest. A company called McKay Brothers LLC recently won approval to build the tallest microwave tower in the area while another, Webline Holdings LLC, has installed microwave dishes on a utility pole just outside the data center.

“It tells you how valuable being just a little bit faster is,” said Michael Goldstein, a finance professor at Babson College in Babson Park, Massachusetts. “People say seconds matter. This is microseconds matter.”

It also tells you something else: at its core, modern trading is simply about being faster than your competition: no thinking goes into the trade, only reaction times matter. That, and frontrunning your competition. Some more details about this literal land grab:

In October 2015, McKay Brothers, a company that sells access to its microwave network to high-speed traders, leased land diagonal to the CME data center, under the name Pierce Broadband LLC, according to DuPage County property records.

Last month, the county gave McKay approval to erect a 350-foot high microwave tower that could be 600 feet closer to the data center than its current location, records show. Two trading firms, IMC BV and Tower Research Capital LLC, own minority stakes in McKay. Co-founder Stephane Tyc said his firm may never build the tower but it would be part of the firm’s continual efforts to speed transmission time.

Then there’s Webline Holdings. In November 2015, it was granted a license to operate microwave equipment on a utility pole just outside the data center, according to Federal Communications Commission records. Webline has licenses for a microwave network stretching from Aurora to Carteret, New Jersey, where Nasdaq Inc.’s data center is located. Messages left for Webline were not returned.

Back to the mysterious antenna: according to Bloomberg, the license for the transmission dishes is held by a joint venture between World Class and a unit of KCG Holdings, another HFT trading firm that was recently acquired by Virtu Financial. In other words, the “who is who” of HFT has been unleashed on an empty field near Chicago, and to the builder will go the spoils. It could be billions in revenues.

After all this frentic building of microwave tower, who is closest to the CME servers? It is unclear. Trading data first leaves CME computers via fiber cable, and then to nearby antennas that send it by microwave to other towers until it reaches New Jersey, where all the major U.S. stock exchanges house their computers. The moves in Aurora are intended to reduce the time that the data is conveyed through cable; the practical impact is shaving off a millisecond or maybe even a few nanoseconds.

At its core, the race is about latency arbitrage, and not being the slowest firm on the block – a recipe for financial ruin. Sending data back and forth between the U.S. Midwest and East Coast allows high-frequency traders to profit from price differences for related assets, including S&P 500 Index futures in Illinois and stock prices in New Jersey. Those arbitrage opportunities often last only tiny fractions of a second.

Ironically, all the land grab and overpriced land purchases could be made obsolete with one simple decision: a microwave tower could be installed on the roof of the CME data center to eliminate the need for jockeying around the site, the same way the NYSE has a microwave tower next to its NJ headquarters. The exchange is indeed looking at allowing roof access, along with CyrusOne, the company that bought the data center last year, CME said in a statement. Traders being traders, however, they may continue to battle, this time for the most advantageous position on the microwave tower itself.

“We are confident the CME can provide an alternate and better solution which offers a level playing field to all participants,” said McKay’s Tyc.

Which is ironic because at its core, modern High Frequency Trade is about everything but a level playing field: after all there are millions of traders to be frontrun, take that away, and the HFT parasites of the world have no advantage whatsoever.

Much Doubt Surrounds VIX Index’s Optimism

From Moody’s

Financial markets were recently visited by a rarity. During the past week, the VIX index closed under 10 points on May 8 and 9. Since its start in 1990, the VIX index has closed under 10 points on only 11, or 0.1%, of the span’s nearly 7,000 trading days.

Today’s very low VIX index reflects a great deal of confidence that there won’t be a deep sell-off by equities. Not only is there effectively little demand for insuring against a harsh correction, but sellers of such insurance are will to accept a low price for protection against a market plunge.

This insouciance seems odd given how richly priced the US equity market is relative to corporate earnings and the prospective returns from other assets such as corporate bonds. The current market value of US common stock — according to a model based on pretax profits from current production and Moody’s long-term Baa industrial company bond yield — exceeds its midpoint valuation by a considerable 24%. During 1999-2000’s memorable equity rally, the market value of US stocks first climbed 24% above its projected midpoint in 1999’s first quarter and would remain at least that high through 2000’s second quarter. During January 1999 through June 2000, the actual market value of US common stock exceeded its projected midpoint by 51%, on average.

Another comparison of the two periods shows a similarly striking difference between them. The earlier period averages of a 15.4:1 ratio for the market value of common stock to pretax operating profits and 8.05% for the long-term industrial company bond yield were far above the recent ratio of 11.7:1 and the latest Baa industrial yield of 4.68%.

In stark contrast to the current situation, during January 1999 through June 2000 the VIX index averaged a substantially higher 24.3 points when the market value of US common stock was at least 24% above its projected midpoint. Back then, the market had a greater appreciation of the considerable downside risk implicit in an overvalued equity market.

Two prior cases of a below-10 VIX index preceded vastly different outcomes

January 2007 and December 1993 were the two prior moments when the VIX index spent some time under the 10-point threshold. What followed them differed drastically.

January 2007 was merely 11 months before the December 2007 start to the worst recession since the Great Depression. In contrast, December 1993 was followed by 1994’s 4.0% annual advance by real GDP that was the first of a seven year span that had real GDP growing by a now unheard of 4.0% annually, on average. Far different was 2007’s 1.8% annual rise by real GDP that was at the start of what would be real GDP’s 0.9% average annual rise of the seven-years-ended 2013.

In the year following December 1993’s ultra-low VIX score, the market value of US common stock fell by -3.2% despite 1994’s 18.6% surge by pretax operating profits. A lift-off by the average 10-year Treasury yield from Q4-1993’s 6.13% to Q4-1994’s 7.96% was to blame for 1994’s short-lived drop by share prices. Nevertheless, partly because of 1994’s very strong showing by business activity, the earnings-sensitive high-yield bond spread narrowed from Q4-1993’s 438 bp to Q4-1994’s 350 bp.

For the year following January 2007’s brief stay by a less than 10-point VIX index, a drop by the 10-year Treasury yield from January 2007’s 4.64% to January 2008’s 4.00% failed to stave off a -3.4% drop by the market value of US common stock largely because of yearlong 2007’s -7.5% contraction of pretax operating profits. A swelling by the high-yield bond spread from January 2007’s 287 bp to January 2008’s 674 bp stemmed from the worsened outlook for business activity.

VIX Index and high-yield EDF differ drastically on yield spreads

May-to-date’s average VIX index of 10.4 points favors a 312 bp midpoint for the high-yield bond spread, which is much thinner than the recent actual spread of 377 bp. Throughout much of 2016, the VIX index proved to be a reliable leading indicator of where the high-yield spread was headed. Nevertheless, if only because the VIX index now resides in the bottom percentile of its historical sample, a higher VIX index is practically inevitable. Once the VIX index approaches its mean, the high-yield spread will be much wider than the recent 377 bp. (Figure 1.)

Housing Slump & Eurozone Key Australian Investor Concerns

High household debt and further strong house-price gains are fuelling Australian investor’s concerns around a domestic housing-market downturn, according to Fitch Ratings’ latest survey of the country’s fixed-income investors. Investors also believe developments in the Eurozone now pose a greater risk to Australian credit markets than a China hard landing.

The 2Q17 survey was undertaken in partnership with KangaNews – a specialist publishing house that provides commentary on fixed-income markets in Australia and New Zealand. Findings represent the views of managers of more than AUD300 billion of fixed-income assets, accounting for over three-quarters of Australia’s domestic real-money market.

Australia is facing mildly tougher economic conditions according to fixed-income investors. Their outlook for three key economic indicators suggests the next three years will see modest interest rate increases, a drift to slightly higher unemployment and house price declines. Interestingly, 60% of investors expect house prices to rise by between 2% and 10% by end-2017, while 52% expect house prices to decline by between 2% and 10% by end-2019.

Investors believe banks are better placed to manage risks, despite their less-than-rosy economic outlook, following steps taken to strengthen bank balance sheets and tighten lending standards. Property market exposure remains investors’ key concern, but the proportion ranking it as ‘critical’ has dropped to 30%, from 43% in our previous 4Q16 survey.

Corporate Australia’s credit profile is also expected to strengthen, with more investors taking the view that corporates will deleverage. The proportion of investors expecting corporate leverage to decrease has risen to 23%, from 4%, over the three surveys conducted over the past twelve months. Investors have nominated the corporate asset class as their preferred investment choice.

Australian investors anticipate a strong rebound in structured finance RMBS and ABS issuance over the next 12 months. Fifty-eight percent believe there will be increased issuance in 2017, up from just 16% in our 4Q16 survey.