1. Asset valuation
Overall, asset valuations and risk appetite remain somewhat elevated
Asset valuations remain high relative to their historical ranges in several major markets, suggesting that investor appetite for risk is elevated. Compared with the previous FSR, valuation pressures have eased slightly. Equity prices relative to forecast earnings remain above the median value over the past 30 years. Spreads on high-yield corporate bonds over benchmark rates are inversely related to valuations and are low relative to their historical range. However, spreads on leveraged loans over benchmark rates have widened since the previous FSR and now are above the median value over the past 20 years. Prices have been growing faster than rents in commercial and residential real estate for the past several years, although price increases in residential real estate have recently slowed somewhat.
Table 1 shows the size of the asset classes discussed in this section. The largest asset classes are those for residential real estate, equities, and commercial real estate (CRE).
Table 1. Size of Selected Asset Markets
(billions of dollars)
|Residential real estate||33,945||5.3||5.5|
|Commercial real estate||18,409||-.1||7.1|
|Investment-grade corporate bonds||5,712||4.9||8.6|
|High-yield and unrated corporate bonds||1,256||-4.1||6.5|
|Price growth (real)|
|Commercial real estate **||-1.4||2.0|
|Residential real estate***||2.4||2.1|
Note: The data extend through 2018:Q4. Growth rates are measured from Q4 the year immediately preceding the period through Q4 of the final year of the period. 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:Q4, as this market was fairly small before then.
** **One-year growth of commercial real estate prices is from Dec. 2017 to Dec. 2018, and average annual growth is from Jan. 1998 to Dec. 2018. Both growth rates are calculated from value-weighted nominal prices deflated using the consumer price index.
*** One-year growth of residential real estate is from Dec. 2017 to Dec. 2018, and average annual growth is from Jan. 1997 to Dec. 2018. Nominal prices are deflated using the consumer price index.
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
Since the previous FSR, yields have fallen for longer-dated Treasury securities (figure 1-1). Treasury term premiums capture the difference between the 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—and the expected yield from rolling over shorter-dated ones. Estimates of Treasury term premiums are near the lowest level of the past 20 years, and an increase in term premiums, if not accompanied by a strengthening of the economic outlook, could put downward pressure on valuations in a variety of markets (figure 1-2). Forward-looking measures of Treasury market volatility derived from options prices are also low by historical standards (figure 1-3).
Spreads on high-yield corporate bonds remain low, while spreads on leveraged loans have widened somewhat from very low levels
The drop in Treasury yields since October has been accompanied by declines in corporate bond yields, which remain at low levels compared with history (figure 1-4). However, spreads on corporate bonds over comparable-maturity Treasury securities, which reflect the extra compensation investors require to hold debt that is subject to default or liquidity risks, are at levels similar to those observed in the previous FSR (figure 1-5). High-yield corporate bond spreads, in particular, are a fair bit below their 20-year median. However, investor appetite for corporate bonds seems to have decreased moderately in recent months. The excess bond premium, which is measured as the gap between bond spreads and expected credit losses and is inversely related to investor risk appetite, is above the low levels observed in recent years and has increased since the previous FSR (figure 1-6).5
Interest rate spreads on newly issued leveraged loans, which widened substantially late last year, reversed part of those increases in the first quarter (figure 1-7). Spreads on lower-rated leveraged loans are above both their historical median and their levels in the previous FSR. Lending standards and loan covenants generally remain weak, reflecting high investor demand for leveraged loans in recent years (see the box "Vulnerabilities Associated with Elevated Business Debt").
Equity market prices relative to forecast earnings appear somewhat elevated
Over the past couple of years, equity prices have been generally high relative to forecast earnings. The S&P 500 forward price-to-earnings ratio dropped significantly over the last two months of 2018, but it subsequently reversed this decline and is now slightly above both its October level and its median value over the past 30 years (figure 1-8). 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 still low relative to its range over the post-crisis period but is slightly higher than it was in the previous FSR (figure 1-9). This premium, however, is well above the low levels seen during the dot-com era. Both realized and option-implied equity market volatility spiked in December and have declined since (figure 1-10). The option-implied volatility measure, which in part reflects expectations about market volatility in the next month, is low by historical standards.
Commercial real estate prices are high relative to rents...
CRE prices have increased substantially over the past seven years, though prices for large commercial properties are similar to one year ago (figure 1-11). However, rents, in real terms, have been stagnant over the past year for most CRE sectors. Capitalization rates, which measure annual rent income relative to prices for recently transacted commercial properties, have been declining steadily since 2010 and are at historically low levels (figure 1-12). Spreads of capitalization rates over yields on 10-year Treasury securities, which are a rough measure of the premium that investors require for holding CRE over very safe alternative investments, have trended down over the past few years and are now at post-crisis lows, although well above the low levels seen in the mid-2000s (figure 1-13). Data from the Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) indicated that CRE lending standards at banks had tightened a bit over the fourth quarter of 2018, which may suggest a modest reduction in risk appetite on the part of lenders (figure 1-14).
...farmland prices are elevated relative to rents and income but are trending down somewhat...
Farmland prices nationally and in several midwestern states have been trending down from their recent peaks but remain high by historical standards (figure 1-15). Moreover, farmland rents have decreased faster than prices, pushing price-to-rent ratios even higher in recent years (figure 1-16). Net farm income remains well below the high levels seen in the early years of the decade, mostly reflecting low agricultural commodity prices.
. . . and house prices have been rising, but less so in recent months
House prices have risen substantially since 2012, although house price increases have slowed materially in the past year (figure 1-17). The aggregate house price-to-rent ratio is higher than its long-run historical trend that includes the effect of carrying costs, but this implied gap is not very large and is far below the extraordinary levels observed in the run-up to the financial crisis (figure 1-18). House price-to-rent ratios vary significantly across regional markets, but the price-to-rent ratios for metropolitan areas at the high end of the distribution are much lower than they were just before the 2008 financial crisis (figure 1-19).
5. For a description of the excess bond premium, see Simon Gilchrist and Egon Zakrajšek (2012), "Credit Spreads and Business Cycle Fluctuations," American Economic Review, vol. 102 (June), pp. 1692–720. Return to text