1. Asset valuation pressures
Overall, asset valuations and risk appetite are elevated
Asset valuations appear high relative to their historical ranges in several major markets, suggesting that investor appetite for risk is elevated. Spreads on high-yield corporate bonds and leveraged loans over benchmark rates are near the low ends of their ranges since the financial crisis. Equity price-to-earnings ratios have been trending up since 2012 and are generally above their median values over the past 30 years despite recent price declines. Commercial real estate (CRE) prices have been growing faster than rents for several years, and, as a result, commercial property capitalization rates relative to Treasury securities are near the bottom of their post-crisis range. While farmland values have fallen in recent years, they remain very high by historical standards. Residential real estate price-to-rent ratios have generally been rising since 2012 and are now a bit higher than estimates of their long-run trend.
Table 1 shows the size of the asset classes discussed in this section. The largest asset classes are those for equities, residential real estate, and CRE.
Table 1: Size of Selected Asset Classes
(billions of dollars)
|Average annual growth,
|Residential real estate||33,274||7.0||5.6|
|Commercial real estate||21,191||8.9||7.1|
|Investment-grade corporate bonds||5,512||3.9||8.5|
|High-yield and unrated corporate bonds||1,302||-.4||6.3|
|Leveraged loans *||1,044||12.9||15.1|
|Price growth (real)|
|Commercial real estate**||3.5||4.0|
|Residential real estate ***||3.1||2.6|
Note: The data extend through 2018:Q2. Equities, real estate, and cropland are at market value; bonds and loans are at book value.
* The amount outstanding shows institutional leveraged loans and generally excludes loan commitments held by banks. For example, lines of credit are generally excluded from this measure. Average annual growth of leveraged loans is from 2000 to 2018:Q2, as this market was fairly small before then.
** Average annual growth of commercial real estate prices is from 1998 to August 2018, and one-year growth is from August 2017 to August 2018.
*** Average annual growth of residential real estate prices is from 1997 to August 2018, and one-year growth is from August 2017 to August 2018.
Source: For leveraged loans, S&P Global Market Intelligence, Leveraged Commentary & Data; for corporate bonds, Mergent, Inc., Corporate Fixed Income Securities Database; for cropland, Department of Agriculture; for residential real estate price growth, CoreLogic; for commercial real estate price growth, CoStar Group, Inc., CoStar Commercial Repeat Sale Indices (CCRSI); for all other items, Federal Reserve Board, Statistical Release Z.1, "Financial Accounts of the United States."
In Treasury markets, yields and term premiums are low...
While short-term Treasury yields have moved up steadily since the Federal Open Market Committee (FOMC) began gradually raising its target range at the end of 2015, longer-term yields have risen more slowly, narrowing the gap between short- and long-term yields (figure 1-1). Treasury term premiums capture the extra yield investors require for holding longer-term Treasury securities, whose realized returns are more sensitive to risks from future inflation or volatility in interest rates than shorter-term securities. Estimates of term premiums have been low for some time, reflecting in part the low and stable level of U.S. inflation over many years (figure 1-2). Forward-looking measures of Treasury market volatility derived from options prices are also low by historical standards, indicating that it is relatively inexpensive for investors to buy protection against changes in Treasury yields (figure 1-3).
. . . and spreads on high-yield corporate bonds and leveraged loans are low even as some credit risks have grown
Consistent with the low level of interest rates overall, corporate bond yields have been low by historical standards for much of the post-crisis period, though they have moved up a bit in recent years as Treasury yields have begun to rise (figure 1-4). Spreads on corporate bonds over comparable-maturity Treasury securities reflect the premium investors require to hold debt subject to default or liquidity risks. High-yield corporate bond spreads are near the lower end of their historical range (figure 1-5). Low expected default rates cannot completely explain the low level of bond spreads; the excess bond premium, an estimate of the gap between bond spreads and expected credit losses, is also near the lower end of its historical distribution (figure 1-6).4
Spreads on newly issued leveraged loans widened a bit over the past few months but remain in the lower end of their range since the financial crisis (figure 1-7). The still relatively low level of spreads is notable given evidence that lenders have become more willing to extend loans with fewer credit protections to higher-risk borrowers. Moody's Loan Covenant Quality Indicator suggests that loan covenants are at their weakest levels since the index began in 2012, although this may reflect, in part, a greater prevalence of investors who do not traditionally exercise loan covenants. The Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) indicates that a moderate net fraction of domestic banks have recently eased lending standards for commercial and industrial loans to middle- and large-sized firms (figure 1-8).
Equity prices are somewhat high relative to forecast earnings
For several years, broad U.S. equity market indexes have been moving upward more quickly than forward-looking corporate earnings forecasts. Although this trend has reversed this year, the S&P 500 forward price-to-earnings ratio remains above its median value over the past 30 years (figure 1-9). The gap between the forward earnings-to-price ratio and the 10-year real Treasury yield, a rough measure of the premium investors require for holding equities, is near the lower end of its range over the post-crisis period but still well above the very low levels seen during the dot-com era (figure 1-10). Both realized and option-implied equity market volatility were low throughout 2017 and much of this year, although both measures jumped up in February and October (figure 1-11).
Commercial real estate prices have grown faster than rents for several years,...
CRE prices have been about flat this year after having risen substantially over the previous seven years (figure 1-12). Capitalization rates, which measure annual income relative to prices for recently transacted properties, have been falling even as Treasury yields have increased (figure 1-13). As a result, spreads of capitalization rates over yields on 10-year Treasury securities are now near post-crisis lows, though well above lows seen before the crisis (figure 1-14). Returns to CRE property investors thus reflect a relatively low premium over very safe alternative investments. Data from the SLOOS indicated that CRE lending standards, which had been tightening in 2016 and 2017, have eased a bit over the past year (figure 1-15).
. . . farmland prices are near historical highs,...
Agricultural land values nationally and in several midwestern states are down from their 2016 peak but remain at exceptionally high levels (figure 1-16). And farmland price-to-rent ratios are at historic highs (figure 1-17). Many farms face possible income losses from retaliatory tariffs on agricultural commodities and other factors, which may not yet be fully reflected in available farmland price measures.
. . . and home prices have been rising, but less so in recent months
House prices have risen substantially since 2012, although the rate of price appreciation appears to have slowed significantly in recent months (figure 1-18). The aggregate house price-to-rent ratio is currently somewhat higher than an estimate of its long-run historical trend but still well below the extraordinarily high levels seen in the years just before the financial crisis (figures 1-19). House price-to-rent ratios differ significantly across regional markets, and in some markets, price-to-rent ratios that experienced large declines during the financial crisis are once again relatively high (figure 1-20). Measures of house prices relative to house-hold income also suggest somewhat elevated valuation pressures in residential real estate nationwide.
4. For a description of the bond risk premium, see Simon Gilchrist and Egon Zakrajšek (2012), "Credit Spreads and Business Cycle Fluctuations," American Economic Review, vol. 102 (June), pp. 1692-1720. Return to text