...market valuations remain elevated. The tight spreads and low volatility in corporate bond markets are hard to square with rising defaults and upcoming higher refinancing costs. Similarly, equity valuations appear stretched.
What was on our minds when we last met in December 2022? At that time, we had just seen the sharpest tightening of financial conditions since the 2008 global financial crisis. We had concerns about elevated debt levels and interconnectedness between banks and non-bank financial intermediaries amid high inflation and a deteriorating growth outlook. In this context, I emphasized that financial stability could not be taken for granted.
So where are we today? Well, these concerns have not vanished; they continue to shape large parts of the FSB’s work.
While inflation has somewhat eased, there is still some uncertainty about the persistence of inflation.
What’s more, market valuations remain elevated. The tight spreads and low volatility in corporate bond markets are hard to square with rising defaults and upcoming higher refinancing costs. Similarly, equity valuations appear stretched.
So, why is the market so upbeat?
Investors prepare for a soft landing, hoping to evade serious challenges in refinancing a wall of maturing debt. Caution is warranted though. Delays in disinflation or negative surprises in the future path of monetary policy may cause sudden repricing.
Moreover, geopolitical tensions add to the already uncertain environment and do not seem to be properly reflected in asset prices. Perhaps because geopolitics is regarded as an ‘unpriceable’ risk; it is zero or one, with an unpredictable probability distribution.
But be it unpredictable or not, the world has been far from dull: surprises may occur. Market shocks could propagate. Volatility in the markets could trigger vulnerabilities in some non-bank investors that are highly leveraged and face liquidity mismatches.
We also remain concerned about indebtedness.
Households, companies and sovereigns too show high debt levels at a time of declining growth rates and high interest rates. Past interest rate hikes are still passing through to borrowers and debt service challenges could still arise. Meanwhile, property prices remain under pressure. For now, the vulnerability is mostly located in a subsector of commercial real estate: downtown office space. We must watch closely if spillovers to different subsectors emerge....
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