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Authorized for public release by the FOMC Secretariat on 08/12/2016 October 28, 2010 Asset Valuation Assessment1 Tobias Adrian, David Bowman, Dan Covitz, Karin Kimbrough, and Fabio Natalucci Broad Themes While valuation measures and indicators in many markets remain within historical ranges, some markets are evolving in a manner that could pose future downside risks to asset prices. Some risk premium measures in the high-yield corporate bond market appear narrow by historical standards. Market participants report a reemergence of pressure to ease credit terms in the leveraged loan market. Treasury risk premiums have continued their recent declines. While this is consistent with reports that investors have become more confident of an announcement of additional large-scale Treasury purchases at the November FOMC meeting, risk premiums now stand at extremely low levels by some measures, raising the risk of abrupt upward adjustment. Analysts' expectations for medium-term corporate earnings growth in a number of foreign countries remain on the high side of their historical norms, which may represent a downside risk to foreign equity prices. In addition, flows into emerging market equity funds (and bond funds) have continued to increase, reportedly reflecting a reaction by some investors to the very low level of interest rates in the United States and perhaps putting upward pressure on valuations. House prices in China, Australia, Singapore, Taiwan, and Hong Kong have continued to appreciate rapidly and in some cases are at historically high levels. Gold prices have continued to rise rapidly this year, and may reflect safe haven and hedging demands that could unwind sharply. Domestic Markets Corporate bond risk premiums have declined over the past two months, retracing much of the widening triggered by last spring's financial turmoil in Europe, suggesting renewed 1 The assessment of asset valuation relies on measures produced by Michael Abrahams, Eric Engstrom, Son Han, Rob Martin, Emanuel Moench, Joe Nichols, Jennifer Roush, Steve Sharpe, Shane Sherlund, Richard Wagreich, and Min Wei. 1 of 19 Authorized for public release by the FOMC Secretariat on 08/12/2016 October 28, 2010 investor willingness to take on credit risk. Far-forward corporate bond spreads, such as nine to ten years ahead—where fluctuations are mostly thought to reflect changes in risk aversion rather than credit risk—have declined to near the bottom of their historical ranges. However, at the same time, near-term (two to three years ahead) forward spreads remain elevated, suggesting that sizable default risks over the next few years continue to be factored into bond prices. Moreover, while historically low yields have spurred a good deal of speculative-grade issuance of late, the share that is rated deep junk (B- or below) moderated in the third quarter. In the syndicated leveraged loan market, the volume of institutional issuance has increased notably over the first three quarters of 2010. In addition, market participants noted that the pressure on credit terms evident in this market earlier in the year—which had subsided in May and June as a result of the European crisis—has reemerged and leverage embedded in deals has increased. Treasury yields generally declined over the past few months, and some measures of nominal and real term premiums are currently at historically low levels. The decline in term premiums is consistent with market reports indicating that investors have become increasingly confident of additional large-scale Treasury purchases being announced at the November FOMC meeting. Low levels of term premiums pose some risk of an abrupt upward adjustment in yields. A sharp increase in Treasury yields could trigger an unwinding of recent gains in riskier assets reportedly prompted by a “reach for yield” in the current low-rate environment. However, judging from option-based measures of uncertainty about longer-term Treasury yields, investors do not appear to see this risk as particularly large. International Markets Foreign equities have risen modestly over the past month, and price-earnings ratios in most cases remain on the low side of historical norms. However, analysts' expectations for medium-term earnings growth in Europe, Japan, Australia, and parts of emerging Asia remain on the high side of historical norms. To the extent these expectations also reflect investor opinions, there could be significant downside risk to equity prices if staff forecasts of sustained, but only moderate, foreign expansion over the forecast horizon prove correct. In 2 of 19 Authorized for public release by the FOMC Secretariat on 08/12/2016 October 28, 2010 addition, flows into emerging market equity funds (and bond funds) have continued to increase, and reportedly reflect in part a search for higher yielding assets by unleveraged institutional and retail investors reacting to very low interest rates in the United States. Rising house prices in China have prompted Chinese authorities to reduce maximum loanto-value ratios. Although such actions may well lead to a gradual slowdown in housing prices, a sharper and more disruptive reversal in the Chinese housing market is not out of the question, and could pose a threat to global financial markets given the growing importance of China to the global economy. House prices in Australia, Singapore, Taiwan, and Hong Kong continue to rise at fairly rapid paces despite the actions taken by authorities to restrain the further rise of currently high prices. A reversal of prices in these countries would likely not pose any systemic risk to the United States, but could create some instability if they sparked wider investor fears about growth in the region. Gold prices have risen a further 30 percent this year, raising the question of whether there is a bubble in the gold market. At least some of this increase is consistent with fundamentals: While demand has risen with global incomes over the last ten years, supply from mines has been stagnant. In addition, rising inflation expectations in China and India (where many investors and consumers buy gold as an inflation hedge), the decline in the value of the dollar, and rising demand for gold from central banks diversifying their reserves may have contributed to the recent rise in gold prices. However, some of the price increases also are likely due to demand from investors who see gold as a safe-haven or who have been attracted by its recent price gains and who may be supporting the continuing rise in gold held by ETFs. Safe-haven demand has historically been quite volatile, and improvements in the global economic outlook could cause a rapid decline in the price of gold. However, a sudden crash in gold prices is unlikely to trigger financial instability, as is it unlikely that financial institutions have substantial exposures to gold relative to their capital buffers. 3 of 19 Authorized for public release by the FOMC Secretariat on 08/12/2016 Table of Contents Page 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Current Focus Subject Equities Implied S&P 500 Return Distribution Corporate Bonds Syndicated Leveraged Loans Bank Credit Treasuries Residential Real Estate Agency MBS Commercial Real Estate International Equities International Housing International Credit Availability/Terms International Credit Commodity Prices Financial Leverage x x x x x x 4 of 19 Authorized for public release by the FOMC Secretariat on 08/12/2016 Equity Valuation Monitor Authorized for public release by the FOMC Secretariat on 08/12/2016 Implied S&P 500 Risk Neutral Distribution Authorized for public release by the FOMC Secretariat on 08/12/2016 Corporate Bond Valuation Monitor Authorized for public release by the FOMC Secretariat on 08/12/2016 Syndicated Leveraged Loan Market Primary Market Secondary Market Authorized for public release by the FOMC Secretariat on 08/12/2016 Bank Credit Bank credit and selected components[ ] n t o f * e s Loans to Businesses Bank Credit Securities Total Loans Loans to Households Commercial and Industrial Commercial Real Estate Residential Real Estate Consumer Growth rates s.a.a.r. (%) Annual: (Q4/Q4) 2007 2008 2009 Quarterly: (average) 2009 Q4 Q1 Q2 Q3 Monthly: 2010 Jun. Jul. Aug. Sep. 10 4 -7 8 5 4 11 4 -10 19 13 -19 9 6 -5 6 -4 -6 10 7 -4 -10 -8 -6 -0 3 3 -1 12 -13 -11 -7 -4 -24 -19 -14 -2 -10 -9 -9 -9 -11 -6 -5 -3 -9 -19 -3 -5 -6 5 2 1 -11 29 14 24 -5 -3 -3 -7 -5 2 0 -4 -10 -10 -8 -10 -4 -5 1 -0 -2 -1 -7 -19 *[All commercial banks. Data have been adjusted to remove the estimated effects of marking to market securities available for sale * e n t o F (FAS 115), the initial consolidation of certain variable interest entities (FIN 46), and off-balance sheet vehicles (FAS 166 and 167) and the effects of nonbank structure activity of $5 billion or more.E ] * e t o f d n Authorized for public release by the FOMC Secretariat on 08/12/2016 Treasury Valuation Monitor Authorized for public release by the FOMC Secretariat on 08/12/2016 Residential Real Estate Valuation Monitor Authorized for public release by the FOMC Secretariat on 08/12/2016 Agency MBS Valuation Monitor Authorized for public release by the FOMC Secretariat on 08/12/2016 Commercial Real Estate Valuation Monitor Authorized for public release by the FOMC Secretariat on 08/12/2016 10- 28-10 International Equities 14 of 19 Authorized for public release by the FOMC Secretariat on 08/12/2016 International Housing Markets Authorized for public release by the FOMC Secretariat on 08/12/2016 International Credit Availability/Terms Authorized for public release by the FOMC Secretariat on 08/12/2016 10- 28-10 International Credit Authorized for public release by the FOMC Secretariat on 08/12/2016 10- 28-10 Commodity Prices Authorized for public release by the FOMC Secretariat on 08/12/2016 Indicators of Leverage
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