February 20, 2020 / 12:45 AM / a month ago

Lofty stocks, hefty debt sow seeds of worry for some at Fed

(Reuters) - Rock-bottom corporate bond yields, high levels of business debt and one of the fastest expansions of stock market valuations on record are worrying some Federal Reserve officials who fret such financial imbalances could aggravate any negative shocks to the U.S. economy.

While agreeing that overall financial vulnerabilities were modest, minutes of the Fed’s latest policy meeting last month, released on Wednesday, showed “several participants observed that equity, corporate debt, and CRE (commercial real estate) valuations were elevated and drew attention to high levels of corporate indebtedness and weak underwriting standards in leveraged loan markets.”

“Some participants expressed the concern that financial imbalances - including overvaluation and excessive indebtedness - could amplify an adverse shock to the economy, that the current conditions of low interest rates and labor market tightness could increase risks to financial stability.”

The minutes showed policymakers remain generally upbeat about the economy even as they acknowledged an emerging risk from the coronavirus outbreak. The readout of the Jan. 28-29 meeting also reinforced a widely accepted view that interest rates are not going up anytime soon.

Still, that one section revealed pointed concerns some inside the central bank have about the risk appetite exhibited by investors and corporations. Stocks are at record highs, corporate debt exceeds $10 trillion for the first time and yields on both high- and low-quality corporate bonds are the lowest ever.

“I agree with their assessment,” said Michael Skordeles, U.S. macro strategist at Truist/SunTrust Advisory in Atlanta. “It’s actually healthy that they’re having those discussions now, while unemployment is at 3.6%, and not waiting until something happens.”

The S&P 500 Index .SPX gained roughly 30% in 2019 and on a rolling 12-month basis is up nearly 22% from where it was at this time a year ago. But what officials are increasingly concerned about is the rapidly rising price investors appear willing to pay for these assets.

The forward price-to-earnings ratio for the S&P, at more than 19 times the next 12 months’ estimated profits, is now the highest since 2002, according to Refinitiv data. In a little over a year, the market’s PE multiple has mushroomed by 33%, the fastest rise in stock prices relative to underlying profits in more than a decade.

It is not the first time Fed officials have flagged lofty asset prices as a concern, and at least one policymaker - Boston Fed President Eric Rosengren - cited financial stability concerns for his decision to oppose the central bank’s three interest rate cuts in 2019.

Indeed, a number of investors say the Fed, through its low-interest rate policy and asset purchases, is at the core of the risk-on atmosphere.

“The irony is that the concerns that assets prices are perhaps too high is that the Fed has enabled this,” said Quincy Krosby, chief market strategist at Prudential Financial in Newark, New Jersey.

(Graphic: Keeping an eye on stock valuations link: here)

Reporting by Caroline Valetkevitch and April Joyner; Writing by Dan Burns; Editing by Richard Chang

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