Fed says stock market boom, ‘bubbling’ investors deserve caution
Booming stocks, internet ‘meme’ investing and the black box of hedge fund financing pose growing risks as the US economy emerges from the coronavirus pandemic and investor appetites soar, a the Federal Reserve warned Thursday in its latest financial stability report.
âWith investors in turmoil over expectations of a strong rebound, it is important to closely monitor risks to the system and ensure the resilience of the financial system,â Fed Governor Lael Brainard said in a statement. CommuniquÃ© issued alongside the US central bank’s semi-annual report reiterated some long-standing concerns and highlighted new ones.
Commercial real estate remains potentially vulnerable, the Fed said, particularly after a pandemic that could decrease demand for office space, and businesses and households “remain under considerable pressure” from the impact of the virus.
An emerging concern: the possibility of a rapid reversal in recent stock market gains, the proven ability of social media to drive up stock prices and just as quickly bring them down, and the worrying implications for risk management when Archegos Capital Management , a family office, failed and resulted in losses at several major banks.
The Fed also called for “structural fixes” in money market funds which had to contend with a series of buyouts at the start of the pandemic and which had to be included in the central bank’s emergency lending programs. .
“The vulnerabilities related to the transformation of the liquidity of these funds remain significant,” the Fed concluded, referring to the fact that the funds offer investors the possibility of disbursing faster than the underlying assets of the fund can be sold. .
Considering the events of the past year, the situation is in many ways better than feared a year ago. Homeowner mortgage defaults, for example, are lower than pre-pandemic levels because of financial support put in place for families; Corporate debt as a whole is high, but strong earnings, low rates and government support “have increased the ability of companies to meet these obligations.”
Banks “remain well capitalized”.
Yet the report exposes a litany of potential short-term risks to the financial system if the pandemic worsens and derails the U.S. recovery.
Asset prices could fall, putting highly leveraged life insurance companies and hedge funds at risk; money market funds could see breaks; and stress in financial markets could interact with potential risks associated with new digital payment systems, according to the report.
If Europe cannot contain the virus and government programs are not favorable enough to offset the negative effects, some major European financial institutions could experience “significant credit losses”, and in turn affect the economy and the US financial system, the report warns. Tensions in emerging markets could also spill over into the United States.
U.S. equity indices have hit or near record highs, with the Standard & Poor’s 500 (.SPX) benchmark rising more than 11% so far this year. It’s about 18% higher than when the Fed released its last Financial Stability Report in November and has nearly doubled from its low point just over a year ago when the pandemic triggered panic. in the markets and plunged the United States into recession.
Corporate profits have generally recovered this year, but the appreciation in stock prices has outstripped improving earnings prospects. This pushed price-to-earnings ratios, a key valuation metric, to high levels and raised concerns among policymakers about âreach for yieldâ behaviors among investors and traders.
Stocks aren’t the only part of the market showing some froth. Risk premiums in corporate bond markets for low-rated issuers have returned to pre-crisis levels.
In its November report, the Fed warned that the United States could still face a wave of debt defaults and âsignificant dropsâ in asset prices due to the pandemic and recession. So far, this has not proven the case.
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