Fed Warns On Vulnerabilities of Stocks and Commercial Real Estate, BIS Warns on Risks from Debt Fueled Growth

The other week the US Federal Reserve issued warnings on US commercial real estate:

From the Bloomberg: (bold mine)

The Federal Reserve warned that prices in the commercial real-estate market may have run up too far too fast.

Valuations in commercial real estate “appear increasingly vulnerable to negative shocks, as CRE prices have continued to outpace rental income,” the Fed said in its semiannual Monetary Policy Report to Congress. The Fed noted that prices exceed their pre-crisis peaks by some measures.

The Fed included a special section on financial stability risks in the report, which accompanies Chair Janet Yellen’s testimony. The report said that even given “moderate’’ financial vulnerabilities, risks of external shocks, such as the U.K.’s possible exit from the European Union, pose stability risks.

The FED also seemed worried over stock market valuations and credit conditions

The report also highlighted issues related to credit exposures to the energy sector, money-market mutual funds and stock valuations.

The central bank said price-to-earnings ratios on a forward-looking basis for stocks have increased to a level “well above” their median for the past 30 years.

“Although equity valuations do not appear to be rich relative to Treasury yields, equity prices are vulnerable to rises in term premiums to more normal levels, especially if a reversion was not motivated by positive news about economic growth,” the Fed said.

The Fed said “some structural vulnerabilities are expected to persist” in money-market mutual funds even after Securities and Exchange Commission reforms go fully into effect in October.

“Leverage for the non-financial corporate sector has stayed elevated and indicators of corporate credit quality, though still solid overall, continued to show signs of deterioration for lower-rated firms, especially in the energy sector,” the Fed said in its report.

Last week, the central bank of central banks, the Bank for International Settlements likewise warned that debt fueled growth is unsustainable.

From their Annual Report. From the first segment

The Conclusion

Judged by historical standards, the performance of the global economy in terms of output, employment and inflation has not been as weak as the rhetoric sometimes suggests. In fact, even the term "recovery" may not do full justice to its current state (Chapter III). But a shift to more robust, balanced and sustainable expansion is threatened by a "risky trinity": debt levels that are too high, productivity growth that is too low, and room for policy manoeuvre that is too narrow. The most conspicuous sign of this predicament is interest rates that continue to be persistently and exceptionally low and which, in fact, have fallen further in the period under review. The global economy cannot afford to rely any longer on the debt-fuelled growth model that has brought it to the current juncture.

The Unholy Trinity

Less comforting is the context in which those economic gauges are evolving and what they might tell us about the future. One could speak of a "risky trinity": productivity growth that is unusually low, casting a shadow over future improvements in living standards; global debt levels that are historically high, raising financial stability risks; and a room for policy manoeuvre that is remarkably narrow, leaving the global economy highly exposed…

Interpreting the evolution of the global economy is fraught with difficulties, but it is necessary if we are to identify possible remedies. As we have in recent Annual Reports, we offer an interpretation using a lens that focuses on financial, global and medium-term aspects. We suggest that the current predicament in no small measure reflects the failure to get to grips with hugely costly financial booms and busts ("financial cycles"). These have left long-lasting economic scars and have made robust, balanced and sustainable global expansion hard to achieve - the hallmark of uneven recovery from a balance sheet recession. Debt has been acting as a political and social substitute for income growth for far too long.

Risks

The first risk concerns the possible macroeconomic dislocations arising from the combination of two factors: tightening global liquidity and maturing domestic financial cycles. It is as if two waves with different frequencies merged to form a more powerful one. Signs that this process was taking hold appeared in the second half of 2015, when foreign currency borrowing peaked and conditions tightened for some borrowers, especially among commodity producers. After the turbulence at the beginning of 2016, however, external financial conditions generally eased, also taking the pressure off the turn in domestic financial cycles. And in China, the authorities provided yet another boost to total credit expansion in an attempt to stave off a drastic turn and smooth out the needed economic rebalancing towards domestic demand and services. As a result, tensions in EMEs have diminished, although the underlying vulnerabilities remain. Events often unfold in slow motion for a long time and then suddenly accelerate....

Even so, prudence is called for. In some of these economies, the increase in domestic debt has been substantial and well beyond historical norms. The corporate sector has been very prominent, and it is there that the surge in foreign currency debt has concentrated even as profitability has declined to levels below those in advanced economies, notably in the commodities sector (Chapter III). While the reduction in that debt appears to have begun, most notably in China, poor data on currency mismatches make it hard to assess vulnerabilities. The growth of new market players, especially asset managers, could complicate the policy response to strains by changing the dynamics of distress and testing central banks' ability to provide liquidity support. In addition, EMEs' greater heft and tighter integration in the global economy indicate that the impact of any strains on the rest of the world would be bigger than in the past, through both financial and trade channels (Chapter III). 

The second risk concerns the persistence of exceptionally low interest rates, increasingly negative even in nominal terms and in some cases even lower than what central banks expected. This risk has a long fuse, with the damage less immediately apparent and growing gradually over time. Such rates tend to depress risk premia and stretch asset valuations, making them more vulnerable to a reversal by encouraging financial risk-taking and raising their sensitivity to disappointing economic news (snapback risk) (Chapter II). They sap the strength of the financial system by eroding banks' net interest margins, raising insurance companies' return mismatches and greatly boosting the value of pension fund liabilities (Chapter VI). And over time they can have a debilitating impact on the real economy. This effect occurs through the channels just discussed, including by weakening banks' lending capacity. But it also arises by encouraging the further build-up in debt and by no longer steering scarce resources to their most productive uses. In effect, the longer such exceptional conditions persist, the harder exit becomes. Negative nominal rates raise uncertainty further, especially when they reflect policy choices (see below).

The third risk concerns a loss of confidence in policymakers. The more time wears on, the more the gap between the public's expectations and reality weighs on their reputation. A case in point is monetary policy, which has been left to shoulder an overwhelming part of the burden of getting economies back on track. Once the crisis broke out, monetary policy proved essential in stabilising the financial system and in preventing it from causing a bigger collapse in economic activity. But despite extraordinary and prolonged measures, monetary policymakers have found it harder to push inflation back in line with objectives and to avoid disappointing gains in output. In the process, financial markets have grown increasingly dependent on central banks' support and the room for policy manoeuvre has narrowed. Should this situation be stretched to the point of shaking public confidence in policymaking, the consequences for financial markets and the economy could be serious. Worryingly, we saw the first real signs of this happening during the market turbulence in February.

Debt Trap

This more symmetrical policy over financial cycles could help moderate them and avoid the progressive loss of policy room that is arguably a serious shortcoming of current arrangements. One symptom of that loss is the relentless increase in the debt-to-GDP ratio, both private and public. Another is exceptionally low policy rates. While part of their decline in real terms surely reflects secular factors beyond policymakers' control, part probably also reflects policymakers' asymmetrical response, which can contribute to the build-up of financial imbalances and to their long-term costs for output and productivity. This raises the risk of a debt trap, whereby, as debt increases, it becomes harder to raise rates without causing damage. And it means that, over sufficiently long horizons, low interest rates become to some extent self-validating. Low rates in the past help shape the economic environment policymakers take as given when tomorrow becomes today. In this sense, low rates beget lower rates (see below).

Huge anomalies (from another BIS study)

Financial markets experienced alternating phases of calm and turbulence in the past year, as prices in core asset markets remained keenly sensitive to monetary policy developments. Investors also closely followed growing signs of economic weakness in the main EMEs, especially China. Bond yields in advanced economies continued to fall, in many cases to historical lows, while the share of outstanding government bonds trading at negative yields reached new records. Low yields reflected low term premia as well as a downward shift in expected future short-term interest rates. Investors turned to riskier market segments in a search for yield, thereby supporting asset prices despite already high valuations. Unease about such valuations, coupled with concerns about the global outlook and about the effectiveness of monetary policy in supporting growth, resulted in recurring selloffs and bouts of volatility. Markets appeared vulnerable to a sharp reversal of high valuations. Some outsize bond price movements point to changes in market liquidity, but lower leverage should support more robust market liquidity under stress. Financial markets also exhibited persistent market anomalies that spread further, such as a widening cross-currency basis and negative US dollar interest rate swap spreads. These anomalies partly reflected market-specific supply-demand imbalances, sometimes reinforced by the impact of central bank actions on hedging demand. They also reflected shifts in the behaviour of large dealer institutions, which are now less active in arbitraging the anomalies away.

Lasting legacy of boom bust cycles and coming changes (from a third study)

Global growth of GDP per working age person slightly outpaced its historical average and unemployment rates generally fell in the year under review. Perceptions of economic conditions, however, were defined by further falls in commodity prices, large swings in exchange rates and lower than expected headline global growth. These developments hint at a realignment of economic and financial forces that have unfolded over many years. In EME commodity exporters, the downturn in the domestic financial cycle mostly compounded the fall in export prices and currency depreciations, with economic conditions becoming weaker. In general, tighter access to dollar borrowing amplified these developments. The anticipated rotation of growth failed to materialise, with activity in advanced economies not picking up as much as needed to offset slower EME growth, despite some upturn in domestic financial cycles in the advanced economies most affected by the Great Financial Crisis. Lower oil and other commodity prices have not yet triggered the expected fillip to growth in importers, possibly because some parts of the private sector are still nursing weak balance sheets. The scars of repeated financial booms and busts and debt accumulation also hang over global potential growth: factor misallocation appears to be holding back productivity, with debt overhang and uncertainty seemingly restraining investment.

In short, all these studies from the BIS represent technical gobbledygook euphemism of the global financial bubble