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The Debt Threat - Part 3

The final blog on the debt threat looks at the risks emanating from Wall Street.

The US Federal Reserve publishes a Financial Stability Review (FSR) as part of its ongoing assessment of the resilience of the US financial system. This examines valuation pressures, borrowing by businesses and households, leverage and funding risks. The May 2019 FSR reports that: “Asset valuations remain high relative to their historical ranges … suggesting that investor appetite for risk is elevated”. This is Fed speak for markets look expensive. The Shiller PE ratio (the cyclically adjusted price earnings ratio or CAPE) is based on average inflation-adjusted earnings from the previous 10 years. As of 11thJune 2019, it stood at 29.73 and was almost exactly the same as on Black Tuesday 1929, and considerably higher than on Black Monday in 1987. But the ratio is considerably less than its record peak of 44 in December 1999, at the peak of the dot.com boom.

In Treasury markets yields remain low, and an increase in yields would result in lower prices – due to the inverse relationship between bond yields and prices. Commercial real estate prices are high relative to rents, but the house price to rent ratio is only slightly above the long-term trend and significantly less than prior to the 2008 financial crisis.

Turning to borrowing, business sector debt relative to GDP is historically high whilst household borrowing has continued to fall as a proportion of income since the financial crisis. Bank capitalisation also looks strong and so there is a mixed picture with regard to the resilience of the US financial system. Of the 3 sources of potential crisis this is perhaps the least worrying.