The Federal Reserve issued a cautionary note Wednesday about risks to financial stability, saying trade tensions, geopolitical uncertainty and a buildup in corporate debt among firms with weak balance sheets pose potentially strong threats.
In what is often a boiler plate report on conditions in the banking system and corporate and business debt, the Fed instead warned of “generally elevated” asset prices that “appear high relative to their historical ranges.”
In addition, the central bank said ongoing trade tensions, which are running high between the U.S. and China, coupled with an uncertain geopolitical environment could combine with the high asset prices to provide a notable shock.
“An escalation in trade tensions, geopolitical uncertainty, or other adverse shocks could lead to a decline in investor appetite for risks in general,” the report said. “The resulting drop in asset prices might be particularly large, given that valuations appear elevated relative to historical levels.”
The drop in asset prices would make it more difficult for companies to get funding, “putting pressure on a sector where leverage is already high,” the report said.
The report further noted that the Fed‘s own rate hikes could pose a threat. A market and economy used to low rates could face issues as the Fed continues to normalize policy through rate hikes and a reduction in its balance sheet, or portfolio of bonds it purchased to stimulate the economy.
“Even if central bank policies are fully anticipated by the public, some adjustments could occur abruptly, contributing to volatility in domestic and international financial markets and strains in institutions,” the report said.
On the bright side, banks and other financial institutions are seen as well capitalized and thus in a good position to absorb shocks. Consumer debt also has kept pace with GDP increases, indicating little threat there. For businesses, though, there could be issues, particularly among those that have added to already high debt levels.
So-called leveraged loans have surged recently, as have companies whose bonds are rated near the bottom end of the investment-grade ladder and are thus susceptible to slipping into junk territory.
“High leverage has historically been linked to elevated financial distress and retrenchment by businesses in economic downturns,” the report said. “Given the valuation pressures associated with business debt … such an increase in financial distress, should it transpire, could trigger a broad adjustment in prices of business debt.”
The Fed noted that the share of investment-grade debt classified at the low end of the range has “reached near-record levels” of $2.25 trillion, or about 35 percent of the total corporate bonds.