05.18.2023 The Federal Reserve released its financial stability report last week, the latest edition of a series published every six months. As a regulator, the Fed focuses on risk from four perspectives, each of which, if left unchecked, could threaten the financial system: valuation, business and household borrowing, financial sector leverage and funding risks. What is the Fed’s take on the current state of things, and how does it compare to ours?
The report also updates a survey of financial system vulnerabilities, asking business leaders, investors and bankers to evaluate the most important risks they believe the financial system faces. The survey revealed a slight decline in the risks posed by persistent inflation as well as the ongoing conflict in Ukraine. The biggest increases in perceived risk were banking sector stress and commercial and residential real estate.
The Fed is on the lookout for asset bubbles that, like housing in 2008, have the potential to burst and cascade through the financial system like falling dominoes. The report concluded that current asset valuations are moderate, with equity and credit markets trading at elevated, but not extreme, levels. US equity price/earnings ratios are slightly elevated, but within historical norms. Corporate bond spreads ‒ the risk premium bond holders require to accept investment-grade credit ‒ are holding steady at median levels.
Property values, both residential and commercial, remain high in the face of higher interest rates despite recent price erosion. The report also observes that delinquencies and defaults are subdued. However, fundamental conditions, particularly for commercial real estate, suggest further price erosion is a risk for lenders.
Too much debt could spur credit defaults at worst or crimp demand at best. Household debt service expenditures relative to disposable income increased slightly, but remains modest by historical standards. Personal balance sheets are fundamentally sound: only a small portion of household debt is pegged to floating interest rates and, thanks to the runup in property values in recent years, very few households have negative equity in their homes. Credit card balances have increased along with a slight uptick in credit card delinquency rates.
Business debt is high relative to GDP, although it has eased slightly in recent quarters. Coverage ratios ‒ the multiple of earnings to debt service ‒ is high (which is a good thing). The report highlights several risks to corporate debt. The sector could be vulnerable should earnings deteriorate. And, considering
that more than half of investment-grade corporate debt outstanding is rated in the lowest investment-grade category, significant downgrades could put pressure on balance sheets and the corporate bond market.
Financial Sector Vulnerability/MODERATE
In a fractional banking system, excess leverage, like a Jenga game, could go horribly wrong if rates spike or a recession hits. Investors witnessed such a collapse during the financial crisis. But the report noted that banks in general are adequately reserved and blamed poor risk management for the recent high-profile banking collapses. Between 2020 and 2021, the banks added $2.3 trillion of securities to their balance sheets, primarily in Treasury and Agency mortgage obligations. Those assets were held at cost, leaving them vulnerable to realized losses if they were forced to sell to cover deposit outflows.
The report also noted the growth of private credit funds, noting that their assets under management as of Q4/21 stood at $1 trillion, with $228 billion of “dry powder” (committed, but undeployed, capital). They acknowledged that the capital flight risk to private credit funds is low. Moreover, the risk to financial stability from private credit funds is also low, thanks to their structures.
Funding risks expose the financial system to a sudden withdrawal of capital. While a handful of regional banks recently suffered outflows, funding risk across the banking sector is low. Silicon Valley Bank, Signature Bank and other banks that relied on uninsured deposits were referred to in the report as outliers. Fed researchers noted that prime money market funds remain vulnerable to runs and contribute to the risks of the short-term funding market. The stablecoin sector is also vulnerable to capital flight.
Bottom Line: In general, we agree with the Fed’s assessment of current conditions. After all, the data we look at is the same data they track. Where we differ is the nominal growth forecast (real GDP growth plus inflation). The Fed is anticipating higher-for-longer inflation, resulting in higher-for longer nominal growth. Under the Fed’s forecast, earnings growth remains elevated and corporate interest coverage remains high, allowing stable credit conditions.
We believe inflation is trending back toward two per cent more quickly, thanks to a slowdown in business spending and hiring, resulting in lower nominal growth. Under that scenario, credit conditions deteriorate more quickly, leading to an acceleration in corporate downgrades and defaults. We are also concerned about housing values. As home prices have deteriorated, existing homeowners are opting to stay put. Cresset’s fair-value model for residential real estate suggests further price deterioration is warranted, with up to 20 per cent downside, given that mortgage rates offset against income gains. Access to home equity has been truncated as mortgage refinance activity has evaporated, leaving a key lever for consumption off the table. Note that we’re calling for a short-lived recession, not a systemic downturn. We believe Powell and Company’s outlook is quixotic, while our caution is realistic.