Rising prices in assets, goods and raw materials are starting to threaten the financial system — and the average investor — the Federal Reserve warned in its May Financial Stability Report.
Overall, the report focuses on the ongoing effects of the pandemic. It states, “If the pandemic persists longer than anticipated — especially if new variants of the virus prove resistant to available vaccines — downward pressure on the U.S. economy could derail the ongoing recovery.”
The Fed stresses that if these developments were indeed to occur, asset prices would suffer significant declines. In addition, highly leveraged firms, aside from financial ones, could see their profits weaken, “leading to financial stress and defaults.” For the average American, the report cautions that “the finances of households, especially those that are financially fragile, could deteriorate, leading to defaults and further pressure on banks and other lenders.”
One of the biggest takeaways from the report for investors is the potential vulnerabilities to those in mortgage forbearance. Forbearance is where your mortgage lender or bank allows you to pause your payments. During the pandemic, many lenders have allowed this. On a positive note, the Fed states that a large percentage of borrowers have already exited forbearance, and in general, those borrowers have loans that are either current or paid off. The ratio of outstanding mortgage debt to home values also remains at a modest level. However, the Fed warns, “Borrowers still in mortgage forbearance may be more vulnerable to the end of government support as well as to adverse shocks. Survey evidence suggests that these borrowers are more likely to be employed in industries hard hit by the pandemic, to have suffered income losses in the past year, and to be delinquent or in forbearance on other forms of debt.”
Prices of risky assets have generally increased, and in some markets, according to the report, are high compared with the expected cash flows of those companies. That means there are significant areas in the market where the value of the asset is not justified. Asset prices may be vulnerable to “significant declines should risk appetite fall,” the report states.
The overall takeaway from the report is that although there are some strong fundamentals, such as positive bank capital and lower ratios of debt than in previous years, the economy is still very much on a fragile road to recovery. Government assistance has largely supported many sectors in economic recovery, and the Fed expects vulnerability as government assistance starts to wean off.
“Vulnerabilities from business and household debt have continued to fall since the November report, reflecting continued government support; nonetheless, business-sector debt outstanding remains high relative to income,” the report states. This means that even in light of government assistance, businesses still owe more in debt than they are taking in, raising implications for performance post-pandemic.
The average investor would do well to stay ahead of this, especially in light of recent news surrounding the inevitable rise of interest rates. While many used stimulus money to invest for the first time in the stock market, now would be a good time to prepare for a pushback against the unprecedented highs of the past year. The adage of “sell high” lends itself well to current market conditions, especially with the Fed itself cautioning of a tightened recovery versus a runaway boom.
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This article originally appeared on GOBankingRates.com: Fed Warns Against Significant Market Losses — What You Should Do to Prepare